In the 1950s, individuals dominated trading. Now institutions with nearly unlimited resources make up 90% of daily trading volume. There are ever increasing 325,000 Bloomberg terminals and 120,000 Chartered Financial Analysts. Technology and the explosion of information have leveled the playing field.
John Meriwether founded LongTerm Capital Management in 1994. For 2 decades before LTCM he earned a reputation as head of the fixed income arbitrage group and vice chairman at Salomon Brothers.
Meriwether had taken it upon to hire the best. He is taunted to have set up a sort of underground railroad that ran from the finest graduate finance and math programs directly onto the Salomon trading floor. – If you are PhD or genius from ivy league, you end up at salomon brothers. Meriwether was stealing an entire generation of academic talent.
Meriwether launched Long Term Capital Management with two giants of financial academia.
- Robert Merton
a) Bachelor of science in engineering mathematics-Columbia University
b) Master of science from the California Institute of Technology
c) Doctorate in economics from MIT
- Myron Scholes
MBA and PhD at the University of Chicago Booth School of Business
Cocreator of the BlackScholes option pricing model
It should be clear by now that the resumes at Long Term Capital Management were truly second to none.
In a Fortune article, Carol Loomis said, “There may be more IQ points per square foot than in any other institution extant.”
Scholes once described themselves as “Not just a fund. We’re a financial technology company.”
The minimum investment at LTCM was $10 million and their management fees were 2% fixed charges and 25% Profit share
Long Term Capital Management opened their doors in February 1994 with $1.25 billion, the largest hedge fund opening ever up until that point in time.
Their returns were high and steady, with their worst losing month being just a 2.9% decline. It seemed too good to be true.
In the fall of 1997, Robert Merton and Myron Scholes both were awarded with the Nobel Prize in Economics.
Big results breeds big envy, and eventually, every trading secret gets out. Everyone else started catching up to them. Opportunities would vanish as soon a they present themselves.
At the end of 1997, after a 25% gain, they made that HUGE decision to return $2.7 billion of capital to their original investors.
when they returned $2.7 billion, they did not take down their position sizes, so their leverage went from 18:1 to 28:1
At one point, they had $1.25 trillion in open positions and they were levered 100:1
In May 1998, as the spreads between US and international bonds widened more than their models anticipated. That is when Long Term lost 6.7%, their worst monthly decline up until that point.
In June 1998, the fund fell another 10%
In August 1998, as oil export fell, Russian stocks were down by 75% for the year. Short term interest rates skyrocketed to 200%. And then the wheels fell off for Meriwether and his colleagues. All the brains in the world couldn’t save them from what was coming.
In August 1998, they calculated that their daily VAR, or value at risk (how much they could lose), was $35 million.
August 21, 1998, they lost $550 million !
By the end of the month, they had lost $1.9 billion.
Intelligence combined with overconfidence is a dangerous recipe when it comes to the markets.