As I’ve explored the idea of robustness, I’ve shared many qualities or characteristics that improve the robustness of an investment strategy. We will now examine a negative example to understand how a hedge fund made all the wrong moves and, after impressive profitability over a number of years, blew up and almost took the world bond market with it. This is the case of Long-Term Capital Management.
LTCM was founded as a hedge fund in order to skirt the regulations on investment funds. This gave the founder and partners more leeway to manage the fund as they saw fit. Robert Merton and Myron Scholes joined as principals and applied their theories which would later gain recognition with prizes in Economics. They used their models to develop a profitable strategy of trading bonds. The success of the investment fund rested on the realism of their models.
The profits that the fund was able to realise on bond arbitrage were slight, so they applied leverage in order to magnify their profitability. By 1998, four years after they began operations, LTCM was running with a debt-to-equity ratio of 100 to 1 or 10,000%. When the market turned down during the Russian financial crisis in August and September of 1998, the equity value of the fund fell, bringing the effective debt-to-equity ratio over 250 to 1. As a comparison, many operating companies function with debt-to-equity ratios of under 1 to 1. Some, such as Apple, have no debt and keep cash on hand for future investment.
LTCM started with around $1 billion in 1994, which is not large in relation to the size of the American bond market. Over the next four years, they raised almost $4 billion more which, after applying leverage, allowed them to control $129 billion of assets. As LTCM grew larger, they exhausted the opportunities they had seen in bond trading. They expanding their strategies to include merger arbitrage and options on the S&P 500. As the size of the fund grew, they worked to remain optimised instead of accepting lower profits with greater certainty.
LTCM was certainly centralised, with a few managers making the decisions about strategy and implementation. However, I don’t see evidence that they suffered from bureaucracy. In fact, these two weaknesses are somewhat exclusive of each other, and I wouldn’t expect to find both of them within a single investment strategy. The principals did invest their own money and collectively lost about $1.9 billion.
A robust investment strategy will give preference to asymmetric payoffs. In the case of LTCM, the asymmetry worked the wrong way. The market efficiency theory of Messrs Black and Scholes posited that there’s no free lunch in financial markets. If there were $100 bills lying in the street, someone else would have already picked them up. Rather, a commentator, Roger Lowenstein, compared the LTCM strategy to picking up “nickels in front of bulldozers”. When market conditions were favourable, returns were small and steady. When market conditions turned difficult, losses came large and fast.
Of the $4.6 billion of losses, $1.7 billion came from investments which were owned directly, in strategies such as pairs trading, merger arbitrage and S&P 500 stocks. The other $2.9 billion of losses came from derivatives such as interest rate swaps and equity volatility contracts.
There’s no question why LTCM generated excitement. They were able to produce consistent returns around 40% per year for four years in a row. This attracted more money to their fund. They continued to take larger and larger bets using more complex strategies based on their models. When the Russian financial crisis caused panic selling in bonds and some equities, the fund experienced margin calls and forced selling, causing financial losses. Financial market watchers were concerned that massive losses and the inability to perform according to contracts would destroy faith in the financial system and orchestrated a huge bailout.
Building robustness into an investment strategy may not seem optimal. It will not maximise profitability in the short-term, but it will maximise the longevity by improving the likelihood of survival. It also has the benefit of maintaining the integrity of our financial system.