He reports that LTCM established an arbitrage position in the dual-listed company (or “DLC”) Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8%–10% premium relative to Shell. In total $2.3 billion was invested, half of which was “long” in Shell and the other half was “short” in Royal Dutch. Investor Seth Klarman believed it was reckless to have the combination of high leverage and not accounting for rare or outlying scenarios. Software designer Mitchell Kapor, who had sold a statistical program with LTCM partner Eric Rosenfeld, saw quantitative finance as a faith, rather than science.
The essential thing is to manage your risk in a consistent fashion and allow for large deviations from observed conditions. Both LTCM and RenTech used a tremendous amount of leverage, and developed sophisticated risk-managing models. But you don’t have to get terribly sophisticated to understand that frequent small, uncorrelated bets with quick profit-taking is far less risky than enormous, correlated bets that may take many months to be realized. How do we invest in unprecedented times and conditions like these? LTCM made the mistake of thinking that the unprecedented conditions they faced were temporary, that things were bound to go back to the way they were, and that this would happen quickly enough to save their hides.
I display hubris from time to time, but try to keep it in check. I trade relatively illiquid stocks, but manage my trades and my portfolio carefully. I’ve done extremely well by taking unusual positions, doing a lot of research, and thinking mathematically. I’m an ignorant amateur compared to the folks in these books. I want to continue When Genius Failed winning, and thinking myself a genius won’t help me with that. After all, I’ve made plenty of mistakes, and I’m certain I’ll continue to make plenty of mistakes. And the missteps that the partners in Long-Term Capital Management made were made not because the formula that they used was wrong, but because they stopped using the formula.
The partners were arbitrageurs who used enormous leverage, and when their positions became too big to efficiently arbitrage, they started to place one-sided bets, or failed to sufficiently hedge, or took liquidity for granted. Managing a small risk is very different from managing a large one, and much easier too. Did genius actually fail, or did the partners stop acting like geniuses?
VaR also couldn’t interpret extreme event such as financial crisis in terms of timing. The model failed to recognize that a financial crisis was a rare event and thus produced biased calculation results. Economist Eugene Fama found in his research that stocks were bound to have extreme outliers. Furthermore, he believed that, because they are subject to discontinuous price changes, real-life markets are inherently more risky than models.
He became even more concerned when LTCM began adding stocks to their bond portfolio. Opaqueness may have made even more of a difference and investors may have had even a harder time judging the risk involved when LTCM moved from bond arbitrage into arbitrage involving common stocks and corporate mergers. LTCM was open about its overall strategy, but very secretive about its specific operations, including scattering trades among banks. If you are hooked, you can finish the book in 12 hours worst come worst in a day. Komansky, who personally had invested almost $1 million in the fund, was terrified of the chaos that would result if Long-Term collapsed. But he knew how much antipathy there was in the room toward Long-Term. He thought the odds of getting the bankers to agree were a long shot at best.
There may not be any parallel in this technique to what either LTCM or RenTech did, since they weren’t stock-picking at all. But successful stock-picking isn’t just finding stinky stocks that nobody else likes, or brilliant gems that are temporarily undervalued. You can do that all you want, but if you’re not a successful When Genius Failed portfolio manager, you’ll find yourself overstretched and on thin ice. Model your portfolio strategy, backtest it, figure out how you can maximize your long-term returns safely, subject your models to the most extreme stress tests you can think of. The way to make money in stocks is to avoid risk, not to court it.
Download one of our FREE Kindle apps to start reading Kindle books on all your devices. Lowenstein’s The End of Wall Streetunfurls a gripping chronicle of the 2008 financial collapse, drawing on 180 interviews with top government officials and Wall Street CEOs.
Deaths Of Despair And The Future Of Capitalism
LTCM managed money for only one hundred investors, it employed not quite two hundred people, and surely not one American in a hundred https://forexanalytics.info/when-genius-failed/ had ever heard of it. The Federal Reserve Bank of New York is perched in a gray, sandstone slab in the heart of Wall Street.
Although termed a bailout, the transaction effectively amounted to an orderly liquidation of the positions held by LTCM with creditor involvement and supervision by the Federal Reserve Bank. No public money was injected or directly at risk, and the companies involved in providing support to LTCM were also those that stood to lose from its failure. The creditors themselves did not lose money from being involved in the transaction. Historian Niall Ferguson proposed that LTCM’s collapse stemmed in part from their use of only five years of financial data to prepare their mathematical models, thus drastically under-estimating the risks of a profound economic crisis.
Meer Boeken Van Roger Lowenstein
Weill was worried that the losses would jeopardize his company’s pending merger with Citicorp, which Weill saw as the crowning gem to his lustrous career. He had recently shuttered his own arbitrage unit-which, years earlier, had been the launching pad for Meriwether’s career-and did not want to bail out another one. James When Genius Failed Cayne, the cigar-chomping chief executive of Bear Stearns, had been vowing that he would stop clearing Long-Term’s trades which would put it out of business-if the fund’s available assets fell below $500 million. At the start of the year, that would have seemed remote, for Long-Term’s capital had been $4.7 billion.
- Richard Fuld, chairman of Lehman Brothers, was fighting off rumors that his company was on the verge of failing due to its supposed overexposure to Long-Term.
- As the other bankers nervously shifted in their seats, Herbert Allison, Komansky’s number two, asked Cayne where he stood.
- David Solo, who represented the giant Swiss bank Union Bank of Switzerland , thought his bank was already in far too deeply, it had foolishly invested in Long-Term and had suffered titanic losses.
- Bear, which cleared Long-Term’s trades, knew the guts of the hedge fund better than any other firm.
- That was why, like a godfather summoning rival and potentially warring- families, McDonough had invited the bankers.
- Thomas Labrecque’s Chase Manhattan had sponsored a loan to the hedge fund of $500 million; before Labrecque thought about investing more, he wanted that loan repaid.
A 2016 CFA article written by Ron Rimkus pointed out the VaR model, one of the major quantitative analysis tool by LTCM, https://forexanalytics.info/ had several flaws in it. But its data sample was biased such that data caused by unusual events were excluded.
Sometimes You Win Sometimes You Learn
But during the past five weeks, or since Russia’s default, Long-Term had suffered numbing losses-day after day after day. If Long-Term defaulted, all of the banks in the room would be left holding one side of a contract for which the other side no longer existed.
But the end was soon in sight, and Lowenstein’s detailed account of each successively worse month of 1998, culminating in a disastrous August and the partners’ subsequent panicked moves, is riveting. James Cayne, the cigar-chomping chief executive of Bear Stearns, had been vowing that he would stop clearing Long-Term’s trades – which would put it out of business – if the fund’s available cash fell below $500 million. But during the past five weeks, or since Russia’s default, Long-Term When Genius Failed had suffered numbing losses – day after day after day. In other words, they would be exposed to tremendous – and untenable – risks. In this case, the shot was Long-Term Capital Management, a private investment partnership with its headquarters in Greenwich, Connecticut, a posh suburb some forty miles from Wall Street. LTCM managed money for only one hundred investors; it employed not quite two hundred people, and surely not one American in a hundred had ever heard of it.
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This recession is already unlike any other; so were the last two, and the next one surely will be too. But one of the merits of Lowenstein’s book is the reminder that there are always bigger mistakes that can be made. The cataclysmic scenario that brought LTCM to its knees was a huge change indices quotes in the bond market that could not have possibly been anticipated. Suddenly everything that was happening was completely without precedent. As a quantitative investor myself, and as someone intimately involved with the quant community at Portfolio123, I take these lessons to heart.