Before Lehman Brothers, there was Long-Term Capital Management. Founded in 1993 by renowned Salomon Brothers trader John W. Meriwether, the hedge fund brought together some of the world’s most well-regarded academics and financial engineers and swelled to $140 billion before it collapsed in 1998. How did it all go so wrong, and what lessons can today’s investors learn from the company's history? To answer these questions, it is instructive to look at the way the fund was structured and who was involved in the creation of this creature.
An all-star team
Besides Meriwether, the two people most closely associated with Long-Term Capital were co-founders Robert C. Merton and Myron Scholes, who were extremely well-established financial academics. In 1997, just one year before the hedge fund blew up, the pair was jointly awarded the Nobel Memorial Prize in economics for the development of “a new method to determine the value of derivatives,” commonly referred to as the Black-Scholes model, which remains the most widely-used options pricing formula. LTCM's investment strategy was based on research carried out by Merton and Scholes, and the fund was widely considered to be on of the best run in the business and used the prestige of having these famous academics on board to attract investors.
The specific methods employed by the fund's managers are beyond the scope of this piece, but there are a few general things that can be said about the them. First, like so many stories of spectacular failure, Long-Term Capital was highly leveraged, employing a debt-to-equity ratio of 25-to-1. Second, the fund took on excessive risk via complex financial derivatives. Third, the key reason why LTCM’s founders were comfortable taking on such risky and highly levered positions was a belief in the financial models developed by its founders and an overreliance on the assumption of mean reversion. In a nutshell, Merton, Scholes and company believed the future could be predicted with reference to the past. Alas, as has been demonstrated time and time again, this was not so.
Lessons for retail investors
If the smartest people in the business can fail so spectacularly, what hope is there for regular investors? Fortunately, there are a number of lessons that we can take away from Long-Term Capital's story that can help us avoid ruin. First, do not get sucked in by promises of huge returns. In 1995 and 1996, the firm posted returns of 59% and 57%, whilst claiming to be bust-proof. Generally speaking, when someone claims to be making huge sums of money out of thin air, there is usually more to the story. More often than not, they are excessively levered, and with magnified gains comes the risk of magnified losses, as the principals of LTCM discovered at great cost to themselves.
Second, do not assume the future will resemble the past. It seems almost a truism to say “past performance is no guarantee of future returns,” but when billions of dollars of investor capital can be wiped out because fund managers assume security prices will always return to their historical averages, it pays to remember this simple fact. To quote a wise trader I once knew: “Don’t worry about buying the bond spread, it always comes back. Until it doesn’t - then you have a serious problem.”
Disclosure: The author owns no stocks mentioned.
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