Friday, October 08, 2010

LTCM and the lessons of failure

Earlier this week we heard the news that John Meriwether, he of the infamous Long Term Capital Management collapse and bailout, would be starting his third hedge fund

It turns out his JM Advisors Mgmt. will be launching two new global macro funds, a switch from Meriwether's tried and true (not really though) relative value arbitrage juiced on leverage approach. 

The idea of Meriwether launching yet another fund, while pursuing a new strategy in the now-hot global macro arena, led me to these thoughts: 

More importantly, it led me to think back to the LTCM crisis and wonder how a once legendary Salomon Brothers trader could find himself at the center of such a disastrous fund blowup. Were there risk controls in place at Salomon that curbed the sort of disastrous, leveraged-fueled strategies favored at LTCM?

Were JM and Co. simply overcome by the hubris of their early success or lulled into assurance by their sophisticated mathematical models? What can we learn from the disastrous failure of LTCM? 

Soon after, I came across a great article that addressed exactly this topic. From the Mercenary Trader blog, here's an excerpt from "Long Term Capital Management and the Lessons of Failure": 

"...For a few good years, LTCM snatched up nickels in front of bulldozers with huge leverage, while the fund’s Nobel laureates got high on their own supply with seriously addle-brained concepts like “Continuous-Time Finance.” Then it all went wrong, in accordance with the “100 year storms” that actually seem to occur every five or six years. 
LTCM, and later vehicles of its ilk such as the Bear Stearns High-Grade Structured Credit funds — which had positive returns 40 months in a row before going Kaboom — became living proof of Michael Milken’s admonition that “leverage is not a business model.”
But Meriwether didn’t get the memo, and blew up with the same approach a second time. To be clear, past failure is not always cause to dismiss future success. As most entrepreneurs and traders know, failure can have an upside — IF the result is knowledge, humility and, above all, wisdom gained from one’s mistakes...."
This article is a must read for anyone trading or investing in markets. It's a quick read, but it not only addresses the problems faced by Meriwether and LTCM, it also takes on the disastrous losses faced by some other high-profile investment managers and the lessons that need to be absorbed by every trader or risk-taking entrepreneur. 

Hope this helps you improve your trading. 

Related articles and posts: 

1. What Makes a Great Trader? Managing Risk - Finance Trends.

2. The Danger of Overconfidence - Janice Dorn. 


Anonymous said...

There are three lessons to be learned from these failures.

(1) Any strategy that posts obnoxious strings of winning months such as 40 in a row is undoubtedly a blowup waiting to happen. The lack of normal vol in a return stream is a sure sign of either as-yet-unrealized high skewness and kurtosis, or a Ponzi scheme.

(2)Strategies such as those in (1), above, are excellent for managing other people's money. You attract tons of AUM and get to exercise the fund manager's put when it blows up.

(3) Name recognition and a full rolodex (wow. That shows how old I am. Rolodex) are what you need to get AUM allocated to you, not necessarily to have a strategy that is conducive to building long-term wealth for your clients.

David said...

Very good points, and the recent history of Maddoff, et al. have certainly reinforced the red flag of "too many profitable months in a row".

It is amazing how willing some people are to invest in a new fund with post-blowup manager (although Janice Dorn points out that many go on to score wins w/ their next funds - true?). As you point out, name recognition and pedigree are key in the investment mgmt. business.