The Thing About Being A Genius
I just finished reading When Genius Failed, the story about a huge hedge fund (Long-Term Capital Management) that blew up in the late 1990s after an incredibly profitable 4-year run. Unsurprisingly, their methods were too good to be true and the fund came pretty close to bringing the entire financial system to its knees. The fund was spearheaded by Nobel Prize winners, Wall Street whiz kids, and Ph.D. level mathematicians. They had it all figured out…until they didn’t. Some details in the book might confuse readers without a financial background, but the broad lessons about risk make the story valuable and worthwhile for anybody.
It’s hard for me to pinpoint an exact reason as to why this fund failed. Greed, ego, and plain ignorance all played a part. Buffet has warned investors, “Why risk what we have for what we don’t need?” The greed factor and Buffet’s question certainly have relevance here. Ego was obvious. LTCM was secretive about what they were doing and thought they had the market beat. Even when the tides began to change, they’d blame bad luck or make up other excuses as to why the fund was losing. Finally, ignorance isn’t something we often attribute to the failure of such smart people, but it definitely played a role here. The models work great in a perfect world. How could they have been so blind to assume our world is a perfect one?
Before I share some of the most interesting (and shocking) facts about LTCM, I can’t help but point out a very obvious, and a not-so-obvious irony related to this book. The irony in the name “Long-Term” Capital Management can’t be overlooked. The fund was in existence for about 5 years. Naming a fund like that and then leveraging a portfolio 100-1 with complex, risky trades is the type of foreshadowing you only see in terrible made-for-TV movies.
The other irony relates to the author himself, Roger Lowenstein. Roger is a well-known journalist and financial writer. His book is one of the greatest lessons about risk that has been written in the past 50 years. So what’s ironic about it? Well, Roger also sits on the board of the Sequoia Fund, which has been one of the most successful mutual funds in history. Unfortunately, last year the Sequoia Fund was caught with its pants down by holding more than 30% of its assets in a single stock…Valeant. For those of you unfamiliar with Valeant, the former pharmaceutical high-flier has lost more than 80% of its value in the last 18 months leading to huge losses for the Sequoia Fund. The fund has since re-written its risk rules but the damage has been done. A man who wrote the book on risk-management, didn’t see a time-bomb ticking right under his nose. Ugh. We’re all human…
Anyway, here are some fun facts about LTCM. Don’t forget to pick your jaw up off the floor!
The fund launched in 1994 with $1.2 billion in capital. By 1997 the fund had nearly $5 billion in capital.
Its after-fee returns in its first three years were: 21%, 43%, 41%.
In 1995, LTCM earned a 59% return (before fees). Its cash-on-cash return was likely less than 1%.
To accomplish this, the fund borrowed huge sums of money with little money down by convincing its lenders that their strategies were so good, the risk was minimal.
The partners debated for hours about what the models implied or whether they should do what the models recommended. “Is the model wrong or is this an incredible opportunity.”
Pro-tip: When dealing with financial markets, if you ever find yourself asking whether your model is wrong or you’ve uncovered an incredible opportunity, 99.9% of the time, the model is probably wrong.
In 1997, the LTCM portfolio had 7,600 open positions. By Agust of 1998, this number had ballooned to a “mind-boggling 60,000 individual positions.”
In 1998 Long-Term Capital calculated with mathematical certainty that it was unlikely to lose more than $35 million on any single day. On August 21, it lost $553 million.
In August 1998 the fund lost $1.9 billion, or 45% of its capital.
In the fall of 1998 LTCM had less than $1 billion in capital, but controlled $100 billion of assets and had $1 trillion in notional derivative exposure.
In September 1998 LTCM assured investors that “steps have been taken to reduce risks now, commensurate with our level of capital.”
Thursday, Sept 10, 1998 the fund lost $145 million.
Friday, Sept 11 the fund lost $120 million.
Monday, Sept 14 the fund lost $55 million.
Tuesday, Sept 15 the fund lost $87 million.
Wednesday, Sept 16 the fund lost $122 million.
In 1998 it lost $4.6 billion in less than four months following the 1997 Asian and Russian financial crises. The Federal Reserve was forced to intervene along with 11 other banks to bail the fund out. It was entirely liquidated and dissolved by early 2000.
Risk happens fast!
Breaking the Bank – The story of Nick Leeson