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For centuries, men have held the ambition to be able to beat the market consistently. Year after year many traders try new strategies to be able to win consistently in the market. However, their strategies predictably fail creating the belief that the market is invincible and that the ability to beat the market consistently is nothing but a pipedream!
However, in the early 1990’s this pipedream came to life in the form of a fund called Long Term Capital Management. This fund was created by a bunch of Nobel laureates who had created the option pricing formula. It ran successfully for some years and gave an average return of 40% after deducting fees and commissions. This makes it a gross return of close to 53% per annum. What’s even more interesting is that fact that the founders of this fund ran it like clockwork meaning that there were no leveraged wild bets being placed on the market. Rather, they had a thorough, systematic plan which worked step by step with little volatility.
High returns and low risk made them arbitrageurs i.e. people who generate risk-free profit. However, this massive arbitrage operation came to a grinding halt. The fame and aura of invincibility that surrounded both Long Term Capital Management fund and its founders was destroyed as this fund created a spectacular collapse leaving a trillion dollar hole in the markets. In this article, we will discuss the rise and fall of the Long Term Capital Management fund.
Scholes, Merton and Miller i.e. the promoters of Long Term Capital Management (LTCM) were mathematicians. They believed that the market was inherently random and therefore the only way to be successful in the markets was by understanding the science of randomness i.e. probability. Based on this belief, one of their founders had co-created the Black Scholes formula. This was a formula that was used to price option contracts and began to be used widely in the market. Scholes ended up getting a Nobel Prize for this contribution.
However, Scholes further partnered with Merton and Miller and created a financial model which could make risk irrelevant. This would be done by something called “dynamic hedging”. This meant that if an open position created a risk, this risk could be offset by creating a position that has an opposite risk thereby nullifying the effect.
The founders at Long Term Capital Management (LTCM) called this strategy dynamic hedging and they had developed algorithms that would help them identify such securities within nanoseconds across various markets.
The founders of Long Term Capital Management (LTCM) were already big names in the academic circles relating to finance and economics. Decision makers in various banks had virtually studied under them or followed their opinions via their books. Hence, when it came to light that Scholes, Miller and Merton wanted to raise funds, Wall Street queued up outside their offices.
The reputation of the founders was so stellar that Wall Street banks and investors had to compete with each other for an opportunity to invest in this fund. Even Central Banks like the Central Bank of Italy had invested money in this fund! Within no time, the founders had a huge kitty of $3 billion to invest in the market place and the operations of Long Term Capital Management (LTCM) were soon underway.
For the first few years, Long Term Capital Management (LTCM) was a remarkable success. The founders had lived up their reputation. The first year saw a return of 23% whereas the latter years saw returns which were consistently in excess of 40%, a remarkable feat in the stock markets! All this was happening by itself as the founders of the fund were often seen playing golf or attending conferences during office hours. A passively managed fund generating those kinds of returns was virtually unheard of and Scholes, Merton and Miller came to be hailed as genius!
The spectacular success and invincible business model of Long Term Capital Management (LTCM) faced failure when the markets started behaving irrationally. All the assumptions in the model are based on how the participants in the market would behave under normal circumstances.
However, the Asian crisis sparked an epidemic of abnormality in the market. A crisis that began in Thailand started spreading across Asia into developed countries like Japan and Korea and mayhem ensued in the marketplace.
However, the founders of Long Term Capital Management (LTCM) were supremely confident in their model. Hence they continued to trade even as the rest of the world closed shop! In fact, Long Term Capital Management (LTCM) saw this as a massive opportunity. So much so that they borrowed $100 billion dollars from various banks and started making highly leveraged bets.
Then, the unthinkable happened and Russia, the erstwhile economic superpower defaulted on its debts. This made Long Term Capital Management (LTCM) lose a lot of money. They were losing close to $500 million every single day in mark to market losses on their derivative positions. Before they knew it, their $3 billion equity was wiped off and the Long Term Capital Management (LTCM) was bankrupt leaving other Wall Street firms with over a trillion dollars in counterparty risk and no means to cover it. In retrospect the founders admitted that the market knew something that they did not and their attempts to outsmart the market every time had led to their downfall.
Lastly, the Federal Reserve had to utilize federal money to bail out the creditors of Long Term Capital Management (LTCM). This saved the market in the short term. However, the Fed came under enormous opposition because it had utilized public money to bail out billionaires that were toying with risk!
The entire Long Term Capital Management (LTCM) episode made the investors realise that financial models can be used to understand the market and aid in decision making. However, left to their own devices, the decisions made by financial models can have disastrous consequences especially when the market behavior deviates away from normal.
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