Book review of When genius failed: The rise and fall of long-term capital management by Roger Lowenstein
The word "arbitrage" is magic to the ears of the financial cognoscenti. To arbitrage is to earn profit without bearing risk. Normally, financial markets meticulously apportion out returns to portfolios based on their risk. Most of the time, a riskless portfolio only earns the lowest return possible (e.g. the interest rate on a government bond). Sometimes, briefly, there are opportunities for obtaining high returns without bearing the risk that is normally essential to winning those high returns. When these situations surface, they are called "arbitrage opportunities" and every finance professional feels thrilled when he finds one.
In India, there is a thriving business which consists of watching for pricing errors between NSE and BSE. If there is a price difference, a person can buy the cheaper and sell the costlier, earning the price difference while taking no risk. Similarly, there will be a huge business which will consist of comparing the price of the index futures with the index. When the Nifty futures are "too costly", the arbitrageur will sell futures and buy Nifty, or vice versa.
Arbitrage is a glamorous idea, but in reality it is slow, tedious work. For example, suppose a person does an arbitrage involving 1000 shares of Reliance on NSE and BSE, with a price difference of 20 paisa. This would generally involve blocking capital and/or shares for one to two weeks, in order to earn a measly Rs.200.
Suppose I have Rs.100. Without my doing any work, I can lend it to the Government of India and get back Rs.110 after a year. Suppose I get back Rs.112 (an extra Rs.2) by deploying it into arbitrage for a year. This is nice - because the higher return (12%) was obtained while bearing zero risk - but unexciting.
The way to juice things up is using leverage, or borrowed money. I supplement my Rs.100 with borrowing of Rs.900. With Rs.1000 in hand, my arbitrage activities yield Rs.1120 over a year. Note that since arbitrage is riskless, there is no doubt that I will be able to pay Rs.1000 in reversing my debt. After paying off the debt, I'm left with Rs.120 at the end of the day - a return of 20% on my capital. A return of 20% without bearing any risk - now that is exciting!
The ingredients for this recipe are (a) arbitrage and (b) leverage. To win in this game requires outstanding abilities in arbitrage and an outstanding ability to fund large positions at low interest rates.
The difficulty in arbitrage lies in competition. When NSE first started up, the differences in prices between NSE and BSE were embarassingly large - price differences as large as Rs.10 were occasionally seen on Reliance. Today, it is rare to earn more than Rs.0.25 on Reliance. What has happened is that the tricks of the trade for NSE/BSE arbitrage are now understood by many, and their competition has eliminated the best opportunities.
Derivatives markets offer enormous arbitrage opportunities. This is because, by definition, a derivative is derived from some underlying. The Nifty futures are derived from Nifty. When the two go out of sync, there are arbitrage opportunities. However, as derivatives get more complicated, the procedures employed for doing arbitrage get steadily more complicated.
Lowenstein's book tells the story of a remarkable firm called `Long-Term Capital Management', which got started in the US in 1994. It was setup by a stellar cast of partners, who brought skills in arbitrage, in modern finance and in the upper reaches of the finance profession. Two of the partners of Long-Term were Robert C. Merton and Myron Scholes, who recently won the Nobel Prize for their work on pricing derivatives. They examplified the quality of talent that Long-Term was able to attract, and they helped in bringing in the smartest minds from academic finance into Long-Term.
Long-Term was not a mutual fund. Mutual funds are crushed under a burden of regulatory limitations, reporting requirements, limitations on leverage, etc. Instead, Long-Term was a "hedge fund". Hedge funds are limited liability partnerships where a small number of investors put in extremely large sums of money. Since retail investors are absent, the regulatory burden upon hedge funds is absent, which is greatly enabling for sophisticated financial strategies.
At first, Long-Term worked incredibly well. It had a clear focus on it's goal of avoiding speculative positions and focusing on arbitrage. It had the best minds in the world working on the arbitrage problem. It had the best contacts in the world which enabled extremely generous loans at most favourable terms. The first two years of LTCM's record are a dollar return for investors of above 40% per year, while taking near--zero risk. This return for investors was obtained after paying management fees and expenses of roughly 10%, i.e. the fund managers obtained incredible returns of roughly 50%.
From here on, a couple of things went wrong:
- The ideas and the models used by Long-Term were known to everyone in academic finance. Long-Term proved that it made sense to take these new ideas very seriously, and there was a steady procession of academic economists kick-starting arbitrage work at all major finance houses. This competition dulled the edge which Long-Term had, and started driving returns down.
- Long-Term reacted to this competition in a strange fashion: they were addicted to getting 50% returns, so when margins shrank, they increased their leverage to get back to high returns. Towards the end, Long-Term was leveraged roughly 100 to 1, i.e. there was Rs.1 of capital from investors for assets of Rs.100.
- Long-Term lost sight of the discipline of the arbitrageur, and started naked speculative activities. These were small when compared with the overall position of Long-Term. However, these were very large when compared with the actual assets under management at Long-Term.
- The crises in Asia, Russia and Brazil hurt Long-Term's positions and dried up market liquidity. Long-Term was stuck holding the largest positions in the world in illiquid markets.
These problems conspired to generate a crisis for Long-Term. The positions of Long-Term were fundamentally sensible, even though losses were experienced in August and September 1998. However, the leverage now kicked in the reverse direction, and these losses were magnified into giant requirements for cash to pay counterparties. Meanwhile, liquidity had dried up worldwide and Long-Term's positions could not be sold off since they were so large.
For some time, it appeared that Long-Term would go bust - leaving a trillion dollars of open positions - and unleash a major financial crisis upon the world world. Instead, the US Federal Reserve frowned on a few banks to cobble together temporary financing for the firm, and then close it down.
It adds up to a spectacular story. Unfortunately, Lowenstein does a rather poor job of telling it. Lowenstein comes from an old school, where gut feelings are the only permissible source of ideas in trading, and stock picking is the only acceptable form of investing. The book is imbued with a deep hostility against derivatives, the use of mathematical models, arbitrage, etc. The book is almost written as a morality play: "Look at how bringing academic talent into fund management led to the biggest foul-up in the world".
Lowenstein is simply confused at many points in the book in understanding derivatives, models, and the role of models and judgement in the trading process. He sees the failure of Long-Term as proof that the mathematical models of Merton and Scholes were wrong, and suggests that the way out is to go back to the happy world of finance before mathematical models. He is flat wrong on this score. While Long-Term did fail, part of the reason why it failed was that all its competitors adopted similar methods. Every large financial house today has dozens of doctorates in economics working on exactly the sorts of models and quantitative trading strategy which (in Lowenstein's view) were the essence of the Long-Term debacle.
Indeed, some of the biggest blunders in the Long-Term story took place when its traders started undertaking speculative bets in the old-fashioned model-free fashion. It is hard to see how the Long-Term story supports Lowenstein's view, that the conversion of finance from a country club profession to a scientific effort is innately flawed.
I read the book with great interest, and took away a different set of lessons:
- An operation like Long-Term should take care to stay small. A fund with $0.5 billion in assets will never have the difficulties which Long-Term, which had $5 billion in assets, experienced.
- Greater care is called for in leveraging.
- The operation should be careful to block any trades that come from the gut; every trade (whether arbitrage or speculation) should be backed by quantitative models and given adequate scrutiny from inception to the trade.
In short, Long-Term is a great story, and Lowenstein is the wrong book. On Amazon, I see another title Inventing money: The story of LTCM and the legends behind it by Nicholas Dunbar. It might make better reading.
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