Friday, October 8, 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:

The news that J. Meriwether is starting his 3rd fund, a global macro fund, has me wondering if we're nearing a top for that strategy.Tue Oct 05 20:22:06 via web

Which is not to say "global macro is over", but that mass acceptance of said fund strategy may be heralding a severe winnowing out process.Tue Oct 05 20:24:45 via web

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 & 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, investing in, or studying 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 you enjoy it and get something out of it.

Related articles and posts:

1. The Danger of Overconfidence - Janice Dorn at The Market Oracle.