The smartest guys in the room

Genius in finance is over-rated

“To make money they didn’t have and didn’t need, they risked what they did have and did need. And that is just plain foolish. If you risk something important to you for something unimportant to you, it just doesn’t make any sense.”

• Warren Buffett on “the smartest guys in the room”.

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Roughly a quarter century ago, the smartest investors in history went bankrupt.

Do you know where you were or what you were doing at the end of September 1998? This correspondent does. He was managing money for private clients at the offices of Merrill Lynch Private Banking in Chester Street, Belgravia.

A colleague sidled up to us one afternoon and whispered that David Komansky – the CEO of Merrill Lynch – had demanded that the heads of every major business unit in the firm report their full trading exposure to Long-Term Capital Management (LTCM) before the close of play that day. Something had clearly gone badly wrong at LTCM.

We knew vaguely of the firm because we’d sometimes fielded calls from its fund managers at our previous employers, Paribas, during the mid-90s. LTCM had been founded by John Meriwether, the former head of bond trading at Salomon Brothers, at a time when Salomon dominated the bond market. (Meriwether has a good cameo role in Michael Lewis’ excellent Liar’s Poker, one of the funniest books ever written about Wall Street.)

LTCM’s board of directors included Myron Scholes and Robert Merton, who won the Nobel Memorial Prize in Economic Sciences for their work in developing options pricing.

Some of the LTCM staff were also among the most objectionable financiers you could ever hope to meet. At one fund-raising round for what was once the most prestigious hedge fund on Wall Street, in late 1993, a young trader at the US insurance company Conseco scoffed at the idea that LTCM could reap massive profits simply from arbitraging (exploiting tiny price differentials) between the most liquid US Treasury bonds and only somewhat less liquid government and corporate paper.

The US Treasury market is, after all, a multi-trillion dollar market and is hyper-efficient. How could these guys make so much money from such a huge and efficient market? The future Nobel laureate, though not exemplary “people person”, Myron Scholes, immediately snapped back:

“You’re the reason. Because of fools like you, we can.”

This to the very people they were trying to raise money from. It’s a marketing pitch of sorts, we suppose. The anonymous Conseco guy would have the last laugh; LTCM would go on to lose $553 million in a single day.

Question 1: why did LTCM go bust?

Two main reasons.

One was that it placed too much reliance on relationships between historical price data sets only going back a short period of time and the assumptions of which were ergodic; that is to say, their price assumptions drew from a principle from the world of mathematics and physics whereby a sufficiently large selection of data points can provide an accurate statistical picture of not just the past but the future, and embrace all possible outcomes.

The reality, however, was that in the aftermath of the Asian crisis of 1997-8 and then the Russian ruble devaluation and debt default of 1998, prices in financial assets started to swing more widely than the Nobel laureates at LTCM were expecting. In other words, LTCM thought it could predict the future with accuracy, and it couldn’t.

All of a sudden, in the midst of a market panic, investors decided that they wanted to own only those US Treasuries which offered the highest possible liquidity. These bonds are known technically as “on the run” issues. Investors were so concerned about securing this enhanced liquidity that they weren’t happy owning even “off the run” US Treasury bonds displaying slightly less liquidity (whose prices thus traded on slightly wider bid-offer spreads).

This was a big problem for LTCM, because its portfolio tended to be concentrated on “off the run” bonds (LTCM was expecting mean reversion on the basis of far too little historic data). Those bonds declined in price relative to the “on the run” issues that LTCM was actually short of.

To put it another way, its portfolio was crushed from two directions at once. What it held long positions in went south, and what it was actually short of went through the roof. Unlucky.

The second reason LTCM went bust was why most hedge funds ultimately fail, or close, namely leverage. By September 1998, LTCM had equity capital of $600 million supporting gross futures exposure of $500 billion and swaps exposure of $750 billion. It also held over-the-counter derivatives exposure of more than $150 billion. Its leverage ratio had reached an extraordinary 250:1. With that degree of leverage, a loss on your overall portfolio of less than half a per cent is sufficient to wipe you out entirely.

(A third reason LTCM failed is that once the rest of Wall Street twigged what was going on, traders at other firms started betting against what they presumed were LTCM’s trades, exacerbating the price movements that were already proving terminal for the ailing hedge fund. As they say, there’s no honour among thieves.)

Question 2: so what?

For a brief period in September 1998, capital markets froze up. There was broad concern at the time that given its exposures to a multitude of banking and financial counterparties (does any of this sound familiar?) the US financial system could have collapsed. There was consequently a desperate but ultimately successful bailout administered by the Federal Reserve.

All of the 14 primary counterparties and creditors to LTCM chipped in to rescue the hedge fund with $3.6 billion of fresh equity, enabling the rescue consortium to unwind its portfolio in as orderly a manner as was possible. All of them, that is, except the investment bank Bear Stearns, which as LTCM’s prime broker felt that it was already sufficiently exposed, thank you very much. For not being a team player, Bear Stearns would suffer its own Götterdämmerung during 2007 and it would be gobbled up by JP Morgan in March 2008.

LTCM’s failure in 1998 was a big deal not so much for the colossal stupidity and greed displayed by its various protagonists, but because it validated a concept that would be fully endorsed a decade later on Wall Street: that of the financial organisation that is “too big to fail”.

It also validated the sort of unchecked moral hazard that would allow central banks first to slash interest rates in response to a financial market panic, and then to pour unlimited resources into the markets to bid up stock and bond prices, thus ensuring that the inevitable free market liquidation that comes after years of massive malinvestment and price distortion will be truly spectacular – quite probably biblical in scale and market impact.

Yes, the last few years have, with hindsight, been great years for investors in Western stock markets – though not quite so profitable for investors in the UK as opposed to the US. But the last few years have also seen monetary stimulus at levels never experienced before in history, leaving US equity markets looking distinctly toppy.

In a recent Epsilon Theory research note, Ben Hunt discussed how dysfunctional politics can give rise to dysfunctional markets. The collapse of LTCM in 1998 matters because it amounted to a dress rehearsal for 2008 and all the bad practices that central banks have embraced with enthusiasm ever since. Without LTCM we might never have had the Greenspan put.

Without the Greenspan put we might never have had “too big to fail”. Without the rise of “too big to fail” we might never have had a credit boom on steroids that culminated in the worst financial crash in our lifetimes, and we might never have experienced the joys of either quantitative easing (QE) or zero interest rate policy (ZIRP).

One of the inevitable by-products of the bailouts in both 1998 and 2008 was a shift in popular attitudes towards politicians and their technocrat agents at the central banks. QE and ZIRP did at least three profound things. One was to facilitate a dramatic expansion in government debt. One was artificially to lift the prices of most financial assets. The third was to make the asset rich even richer, and to drive a wedge between the wealthy and the poor.

Ben Hunt absolutely nails the sense of lingering frustration most likely felt, to a greater or lesser extent, by all post-crisis investors – except those who have had the luck, or judgment, to be invested solely in US large cap stocks. As he asks,

“What drives our disappointment? For a decade now …

• It is a fact that NONE of us have done as well in our individual real-life portfolios as ALL of us have done in aggregate hypothetical indices.

• It is a fact that Value has waaay underperformed the S&P 500.

• It is a fact that Trend has waaay underperformed the S&P 500.

• It is a fact that Quality has waaay underperformed the S&P 500.

• It is a fact that Emerging Markets have waaay underperformed the S&P 500.

• It is a fact that Real Assets have waaay underperformed the S&P 500.

• It is a fact that Hedge Funds have waaay underperformed the S&P 500.

• It is a fact that smarts and experience of every sort have waaay underperformed the S&P 500.

“And if that weren’t enough, here’s the kicker that’ll get everyone mad at me, because it challenges the central tenet of the Church of Modern Portfolio Theory.

“It is a fact that diversification has failed us for a decade.

“The entire edifice of diversification and Modern Portfolio Theory is built on a simple and powerful idea – that it is meaningful to talk about uncorrelated asset classes and factors with positive expected returns. It’s built on the belief that all of these Things we call asset classes or factors will work over the long haul, but not all of them will work all of the time or in lockstep with each other, so you’re (much) better off owning a mix of these Things rather than just one of these Things.

“Put another way, well-diversified portfolios work great in a widening gyre.

“But our current market equilibrium is the opposite of a widening gyre. Where our politics have moved from a roughly single-peaked distribution of electorate preferences to a bimodal distribution, so that there is no effective centre, our markets have moved from a multi-modal distribution of investor preferences to a single-peaked distribution, so that it’s all US large-cap stocks all the time.

“If our politics are a widening gyre, our markets are a black hole. In both cases, resistance is futile. Fight the political centrifuge spinning you into the extremist arms of a two-party system … and you are left behind as an impotent “centrist”. Fight the investment gravity pulling you into passively managed large-cap US stocks … and you are left behind as an impotent “diversifier”.

“Here’s the bottom line for how Things Fall Apart in the widening gyre of modern politics. In a two-party system with high-peaked bimodal electorate preferences:

“There is no winning centrist politician.

“There are no stable centrist policies.

“And here’s the bottom line for how Things Fall Apart in the black hole of modern investing. In a multi-asset class market with high-peaked unimodal investor preferences:

“There is no winning diversification advocate.

“There are no outperforming diversified portfolios.

“Sorry.”

A portfolio dominated by US large cap stocks is not one we could have endorsed back in early 2009 and certainly not at today’s valuations. To adopt Hunt’s language, although diversification has “failed us” for a decade, it doesn’t mean that it will always fail us. Failure in this context is in any case relative.

The time to wholeheartedly embrace a capital preservation approach – and broad asset diversification to boot – is precisely when it seems that (US) stock markets can only ever go up. But 15 years or so into the rally seems like exactly the wrong time to be throwing babies out with the bathwater and just indexing everything.

If there was ever a time to be embracing caution, now is surely it. More to the point, now seems like the perfect time to start building or rebuilding exposure to the most insurance-like parts of our portfolios.

Namely the gold and silver-related vehicles, including the miners, and the systematic trend-following funds that have done good work for us of late. There is still room for sensibly priced equities. The problem is that precious few of them can be found in markets like the US.

It is, admittedly, quite clear that we live in an environment in which new digital businesses can achieve global scale – and profits to match – using a distinctly capital-light model. It is also clear that for precisely that reason, all kinds of more traditional, less digital-friendly businesses are being either torn apart or being made essentially functionally irrelevant at blinding speed. Think publishing, media, transportation, hotels, retailing…

But unless you believe that the business cycle has been eliminated, that vast and unprecedented market intervention can be practised for well over a decade without consequences (including real world inflation), that the bond markets of the world will shrug off rising US interest rates, and most importantly that human nature and emotion has somehow profoundly changed since 2008 (or 1998), then you must accept that at some point, well, Houston, we are going to have a problem. Or as the US author and asset manager Jim O’Shaughnessy puts it:

“Markets change minute by minute. Human nature barely changes millennium by millennium. There’s your edge.”

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As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio – with no obligation at all:

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Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.

Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks.