This weekend I finished reading a great book.
A friend recommended it a year or two ago, and I finally got round to it.
When Genius Failed is its name.
It reads a bit like Barbarians at the Gate, that famous story of the ginormous leveraged buyout of RJR Nabisco. That book taught the public about the greed and self-interest of Wall St in the 1980s.
When Genius Failed is similar, but tells a different story.
A cautionary tale, if you will.
It follows the rise and (“spoiler alert”) fall of a hedge fund in the 1990s called Long-Term Capital Management (LTCM).
LTCM was an arrogant and secretive attempt of high-flying traders, academics, and Nobel prize-winning economists to model away risk.
By using the latest theories and models to determine risk, they felt confident enough in predicting future market fluctuations to take on huge leverage.
By taking on debt to use as leverage, a quarter per cent margin on a trade could turn into double-digit returns.
They grew bolder with each successful month, and year.
The principle behind it was that they could model the markets. That they followed predictable patterns. That they were logical.
The idea was that there was a right price and a wrong price. Any divergence from the “right” price was merely an opportunity to profit from the return to the “correct” order of things.
Well, what’s that old investor’s saying?
“The market can be wrong longer than you can stay solvent.”
And so it was for LTCM and its secretive, supercilious partners.
The crunch came in 1998, when Russia defaulted on its debt. Shockwaves rippled through emerging markets.
As investors fled from risky assets, LTCM’s bets on low volatility and a return to calmer waters went the wrong way.
And because of all its leverage, it went big.
Contagion spread through countries and asset classes.
A catastrophe which its models predicted would happen once every few hundred million years or so unfolded day by day, within five years of the fund’s inception.
As the size of its fund shrank, it fell under ever greater risk of default.
Its undoing was in not seeing that markets move upward in hordes, and retreat in unison. “Sensible” traders do not immediately seize on the opportunities provided by panicking investors. They fear the trend.
Big banks saw the panic in emerging market bonds and decided to cut their losses and get out of that risky business.
LTCM meanwhile saw panic selling as an opportunity, but it was alone.
Greed had dominated the mid-90s, and LTCM was the greediest, and thus the most successful in that period.
When fear superseded greed though, LTCM was the most at risk because it had been the greediest.
There’s an Aesop’s fable in here somewhere…
Russia was the trigger for an avalanche, LTCM was the nuclear bomb at the bottom of the mountain.
It had entered into so many deals, with so much leverage, with such an abundance of Wall St banks that it caught the whole of Silly Street in its web.
In the end, the Federal Reserve had to get the heads of every major bank into one room. In a matter of days, the banking chiefs promised to raise $3.65 billion.
Ostensibly to save LTCM, really they were saving themselves. Their exposure to the fund was so huge, LTCM going under would have taken them down too.
Why am I telling you about all this?
Well, it’s a great book, and I recommend it.
And it reminds one never to trust anyone who uses maths and models to magic away risk. Risk takes many forms, and while it can be moved, it can never be removed.
Markets are complex organisms, and people cannot subject them to the regularity of mathematical formulae. People are unpredictable, markets are infinitely complex.
But I’m writing about it today specifically, because this morning I saw a headline from Lipper Alpha Insight.
“Investors Flee Emerging Markets Funds during the Third Quarter”
Followed by:
The emerging markets funds [a group of companies followed by this study] suffered the worst weekly net outflow in its history [since 1993] as $4.1 billion left during the fund-flows week ended August 7. The group has recorded a net negative flow of $10.2 billion for the quarter to date putting it on pace to surpass the second quarter of 2013 (-$13.7 billion) for its worst quarterly fund flows result ever.
Russia was the emerging market whose collapse made investors flee risky EM markets, followed by anything “risky”.
Once the rampage builds, it can be hard to stop. Investors don’t always see falling markets as an opportunity to buy the same asset at a cheaper price. They see a trend, and try to get out before it runs any further.
Could we be seeing the start of something similar today – a flight from EM risk?
Is there an over-leveraged LTCM out there, ready to take the Goldmans and JPs down with them?
A “star fund manager” at Franklin Templeton recently lost $1.8bn in a single day as the world’s largest buyer of Argentina century bonds.
And I also noticed that Ray Dalio’s Bridgewater, the largest hedge fund in the world, was massively short US Treasuries, which have been one of the best performing assets this year.
He had bet that interest rates would rise, knocking bond prices down, but the opposite happened.
After ten years of falling volatility, and rising prices, it would be no surprise to find that some rogue managers have grown overconfident, taken on massive debt in order to leverage their returns.
If that has happened, there could be another LTCM out there, ready to implode.
Over ten years, more and more investors have joined the party, pushing stockmarkets up the world over.
But as investors join the herd of bulls, the effect of a change in direction becomes all the more rampant. Everyone thinks markets will keep going up, while volatility keeps going down. These ideas may be consistent with the decade since the last financial crisis, but that doesn’t mean they will remain so.
Low risk does not mean no risk. Nearly certain does not mean certain.
(Just ask Ben Stokes.)
Best,
Kit Winder
Research Analyst, Southbank Investment Research
Category: Market updates