More on this book
Community
Kindle Notes & Highlights
He understood that behavioral quirks colored the markets, tinting the pure randomness imagined by efficient-market theorists. But Jones was attuned to a different sort of bias too. If investors could buy and sell irrationally for psychological reasons, they could do much the same thing for institutional ones.
The theory presumes that if, say, Ford’s stock was too low, a handful of smart investors could buy Ford shares until they forced the price up to its efficient level. But in reality there is a limit to smart investors’ firepower; they may lack sufficient cash to keep buying Ford until it hits its rational level. When a whole market is out of kilter, the smart investors are especially likely to fall short. They might know that Japan’s equity bubble—or the dot-com bubble or the mortgage bubble—makes no sense, but they cannot borrow enough to bet against it with the force that would deflate it.
...more
Markets can move away from fundamental value because speculators lack the muscle to challenge the consensus; a trend can keep going far beyond the point at which it ceases to be rational. But if you are a trader with more ammunition and courage than the rest, you can ambush the market and jolt it out of its sleepwalk. And because you will have started a new trend, you will be the first to profit from it.
Rather than await the trigger that would make his script for oil come true, Jones had succeeded in creating it.
As one admiring colleague put it, Druckenmiller understood the stock market better than economists and understood economics better than the stock pickers; it was a profitable mixture.
If there was one thing that the disciple had learned from the master, it was to pile on with all you’ve got when the right moment presents itself.
The triumph of macro trading proved, if further proof was possibly needed, that the efficient-market hypothesis missed a large part of the story. If markets were dominated by rational investors seeking maximum profits, then efficiency might possibly prevail; but if markets were driven by players with other agendas, there was no reason to expect efficient pricing. Macro trading exploited a prime example of this insight: Governments and central banks were clearly not trying to maximize profits.
As happens after every financial crisis, the first instinct was to vilify the markets rather than to learn the awkward lessons that they teach:
The Fed wanted to help banks, so Steinhardt turned himself into a shadowbank: He borrowed short and lent long, just like any bank would do. The difference was that Steinhardt bypassed the tedious business of hiring armies of tellers to collect customer deposits and flotillas of credit officers to lend the deposits on to companies. Instead, he borrowed from brokerages such as Goldman Sachs and Salomon Brothers, then lent by buying bonds.
Here was yet another lesson about leverage that was to haunt hedge funds in future years. Not only can it cause a fund to crash. It can complicate its burial.
In another premonition of future troubles, the sheer complexity of these instruments made them impossible to sell. Nobody on the Street knew how to value them.
in the wake of the huge credit bubble in the mid-2000s, the clean-up-afterward approach proved disastrously costly. The case for considering asset bubbles when setting monetary policy, and for requiring financiers to restrain leverage when markets appeared frothy, was belatedly vindicated.
A month after Kovner’s announcement, Soros wrote a letter to Quantum’s investors, blaming recent disappointments on the same problem of size. Macro investing was now contemptuously dubbed “leveraged directional speculating.”
Another classic Meriwether trade involved the Italian bond market.9 Italy’s cumbersome tax rules deterred foreigners from investing in the country’s bond market; as a result, demand was suppressed and the bonds were a bargain. A foreigner who figured out how to get around the tax obstacle could buy the bonds and collect a yield of, say, 10 percent. Then he could hedge the position by borrowing lire in the international money market at perhaps 9 percent, pocketing the 1-percentage-point difference.
In each of these cases, LTCM took the other side—effectively trading against people who were buying or selling because institutional requirements compelled them to do so. By being the flexible player with the freedom to mirror the quirks of the inflexible ones, Long-Term provided liquidity to the markets. French insurers and American banks fulfilled their institutional imperative at a better price than they would otherwise have done. Meanwhile LTCM itself reaped fabulous profits.
IN HIS BEST-SELLING ACCOUNT OF LONG-TERM CAPITAL Management’s brief life, Roger Lowenstein portrays the fund’s demise as a punishment for hubris.
leverage was the very essence of the firm: The pricing anomalies it found were too small to be worth much without the multiplier of borrowed money. In 1995, for example, Long-Term’s return on assets, at 2.45 percent, was modest; but leverage transformed an indifferent return on assets into a spectacular return on capital—2.45 percent became 42.8 percent.
In years to come, critics ridiculed value-at-risk calculations for ignoring the worst day in a hundred, likening them to car air bags that are designed to work all the time except during a collision. But because of the corrective power of arbitrage, ignoring the worst day in a hundred was less reckless than it appeared to be. A bad day for Long-Term would be followed by a better one. The market always tended to spring back. This was the Slinky effect to which Larry Hilibrand alluded. Of course, the tendency to self-correct was only a tendency.
In the wake of LTCM’s failure, it was easy to forget these multiple precautions. Meriwether and his partners came to be seen as the victims of a reckless faith in their models—which fueled the belief that some modest addition of caution could prevent similar disasters. But the truth was both more subtle and harder to live with. LTCM’s risk management was more nuanced and sophisticated than critics imagined, and the lessons drawn from its failure included several prescriptions that LTCM itself had implemented.
LTCM failed anyway, not because its approach to calculating risk was simplistic but because getting the calculations right is extraordinarily difficult.
The real lesson of LTCM’s failure was not that its approach to risk was too simple. It was that all attempts to be precise about risk are unavoidably brittle.
Precisely - so why base your approach on needing to get these right? Just build in shed loads of redundancy and accept lower returns in exchange for no wipeout risk
True to their usual pattern, Meriwether and his partners saw a chance to act as the balancers of irrational panic. They sold call options and put options, collecting the premiums in the belief that they would not have to pay out to buyers. So long as volatility remained within its usual range, the bet could not go against them.
That's a big if
If the fund’s trades had one premise in common, it was that cool heads would prevail: Irrational panic would be corrected by the rational calm of arbitrage.
Exact opposite of black swan investing
LTCM had thought its portfolio was safe because relationships in credit markets were generally stable; now they were stormy. LTCM had thought its portfolio was safe because the correlation between its different strategies was low; with panic driving every market the same way, its positions fell in lockstep. LTCM had thought its portfolio was safe because its value-at-risk estimates suggested it could lose no more than $116 million in a trading day. But now its estimate was off by more than $400 million. Most fundamentally, LTCM had believed in the corrective power of arbitrage. Markets could
...more
Every trade in Long-Term’s portfolio went wrong in a correlated way, not necessarily because they were similar in an economic sense but because they were similar in terms of the types of fund that held them. Looking back on LTCM’s history, Eric Rosenfeld considers the failure to anticipate this trader-driven correlation to be the fund’s central error.
To a predatory trader, the biggest prize in this environment was to short anything Long-Term might own. Meriwether noticed grimly that the LTCM trades that were unknown to Wall Street bounced back after the post-Russia Friday shock; it was the known trades that kept bleeding money.
Sitting among the unmanned workstations in Long-Term’s quiet offices, conferring with a colleague from the Treasury, Fisher confronted a problem that had bedeviled the failure of Askin Capital Management and would haunt regulators in the next decade.47 Firms that entangle themselves with dozens of partners can be too complex and intertwined to be buried easily.
Long-Term had been too leveraged. It had overlooked the danger that its trades could implode spectacularly if other arbitrageurs were forced to dump copycat positions suddenly; it had misjudged the precision with which financial risk can be measured. But there was no reason to suppose that Long-Term’s errors were possible only at hedge funds. Indeed, Long-Term’s collapse had rattled the authorities because it had coincided with frightening losses at investment banks such as Lehman Brothers. In the wake of LTCM’s failure, Greenspan and his fellow regulators could see that the real challenge was
...more
The frustrating truth was that the risks in a portfolio depended on constantly changing conditions: whether other players were mimicking its trades, how liquid markets were, whether banks and brokerages were suffering from compromised immune systems.
By trading currencies even more ambitiously than his rivals at Quantum, Robertson had baked his own Sahara.
All these issues arise because of the size of the bets - a small, Unknown investor could do all of this better than these guys (possibly - although you'd lack the muscle to move the market, or to do block trades etc)
On the one hand there is the optimistic view—that sophisticated traders will analyze prices and move them to their efficient level. On the other hand there is a darker view—that sophisticated traders lack the muscle to enforce price efficiency and that, knowing the limits of their power, they will prefer to ride trends rather than fight them.
For believers in markets, it is hard to accept that intelligent investors would miss the opportunity to short something that is evidently overpriced—indeed, this is what investors need to do in order to justify their existence.
In 1999, Tiger was in danger of unraveling too— not because brokers were calling in their loans but because investors were calling in their equity. In both cases, moreover, widespread knowledge of the hedge funds’ holdings contributed to their troubles. Commentators who insist that hedge-fund transparency would stabilize markets might usefully ponder this lesson.
In the last months of 1999, Druckenmiller made more from surfing tech stocks than he had made from shorting sterling eight years earlier. Quantum went from down 18 percent in the first five months of the year to up 35 percent by the end of it. Druckenmiller had pulled off one of the great comebacks in the story of hedge funds, and it had nothing whatever to do with pushing markets to their efficient level.
He pleaded with his investors that a great technology can change people’s lives without necessarily generating profits for investors. He pointed out that the managers of the companies in Tiger’s portfolio were buying their stock back, suggesting that they regarded their own equity as cheap, whereas managers of tech firms were eagerly selling stakes in their own enterprises.
By pivoting aggressively one too many times, Druckenmiller had failed to escape before the party ended.
In a modern financial system, Swensen reasoned, diversification should mean more than simply holding a broad mix of U.S. bonds and equities: Assets such as foreign equities, real estate, private equity, oil, gas, and timber all offered ways to add equity-type returns while diversifying risk substantially. Then there was another kind of asset that took Swensen’s fancy. He called it “absolute return,” and over the next years the term entered the investment lexicon. It was a synonym for hedge funds.
what really interested Swensen was the scale and source of hedge-fund profits. Hedge funds promised equity-sized returns that were uncorrelated with the market index, offering the free lunch of diversification.
As a young analyst at Morgan Stanley, he had been upset to discover that investment-bank advisers can be paid for being wrong; sounding convincing mattered more than actually being right, since the objective was simply to extract fees from the clients.
Steyer had created what would later be known as an “event-driven” hedge fund. He specialized in events that caused existing prices to be wrong—moments when a disruption suddenly rendered the market’s settled view inoperative.
Exactly what Cornwall Capital did (in The Big Short)
“Great investors tend to have a ‘screw loose,’ pursuing the game not for profit, but for sport,” Swensen wrote later.
As Yale did its due diligence, it found that Steyer had all the qualities that the endowment could hope for. This guy was not running a hedge fund because he craved luxury: You just had to look at his office to see that. This guy shared Swensen’s passion for pure compensation incentives: He insisted that Farallon employees keep their liquid savings in the fund so that they would feel the pain if they lost money.13 Steyer also embraced the convention of a “high-water mark,” meaning that if his fund was down he would take no further fees until he earned the money back for his investors.
At the start of 2000, when Soros proclaimed that the hedge-fund era was over, hedge-fund assets had stood at $490 billion. By the end of 2005, they stood at $1.1 trillion.
From the point of view of endowment managers, who reported to oversight committees that asked skeptical questions, the returns were pleasingly explicable. Macro traders like Paul Tudor Jones might talk about Kondratiev waves and breakout points: To the average investment committee, this was hocus-pocus. But event-driven funds like Farallon involved no mystery at all. These guys studied legal labyrinths. They understood the odds that a given merger would go through. They could judge how a particular slice of subordinated debt was likely to be treated by a particular bankruptcy judge in a
...more
The more endowments displaced rich individuals as the chief investors in hedge funds, the more it mattered that hedge-fund strategies could be understood. A rich investor can bet his personal fortune on a mysterious genius if he so chooses. Endowment committees must protect their backs with PowerPoint presentations.
their returns were almost miraculously steady.19 Farallon’s consistency was legendary: Between 1990 and 1997, there was not a single month in which the fund lost money.
around 2000, the scales fell from his eyes. He was selling Mercedes cars—lots of them, one after the next—to customers who were in the mortgage business. Discovering that he could get a license to sell home loans without taking classes, Sadek embarked upon a fresh career. If he had wanted to become a professional barber, he would have needed 1,500 hours of training to qualify for a state license.
He was less a master of the universe than a master of the Rolodex, as the SEC’s enforcement chief remarked; he had no amazing special sauce, but he had a lot of special sources.
“Where are the customers’ yachts?” the author Fred Schwed demanded in his classic account of Wall Street.
Soros, The Alchemy of Finance,
