This is a month of anniversaries. Five years ago this month, Lehman Bros collapsed dramatically. The global credit system froze. Trust between banks, and between banks and their customers, was shaken. Global trade and activity descended in a frightening downward spiral. Indeed, the descent of the global economy accelerated to a pace not seen since the Great Depression. We are still grappling with the consequences.
While the collapse of the New York investment bank and its aftermath contains many lessons for investors and policy-makers, the anniversary I want to comment on is from 10 years earlier – the September 1998 collapse of the hedge fund Long-Term Capital Management (LTCM).
Although the impact of the collapse of LTCM was short-lived and minor relative to that of Lehman, judging from many client meetings to this day, I believe it contains a crucial lesson for investors that needs recalling.
LTCM was a hedge fund started with great expectations in 1994. By combining the academic credentials of Robert Merton and Myron Scholes with the legendary Wall Street skills of John Meriwether and his ex-Salomon team – the Michael Lewis book Liars Poker gives a wonderful account of their Salomon days – LTCM set out to transform its quantitative mastery of risk into a spectacularly successful money-machine.
The central assumption of the LTCM investment strategy was that the historic volatility of securities prices was a sufficient proxy for future volatility and therefore a credible proxy measurement of risk.
Armed with this ability to model and measure risk, LTCM could profit from exploiting situations where market prices differed from their model prices. Secure in their belief that such market mispricing would be ironed out in time, they could then lever their exposure to these situations to a massive degree and accrue the massive rewards.
Following three years of annualised returns touching 40 per cent and the awarding of the 1997 Nobel Prize in Economics to Merton and Scholes, the strategy and central assumption of LTCM seemed convincingly vindicated. A happy and rewarding future beckoned for the Connecticut-based money-machine and its lucky clients.
Nine months after the triumph of the Nobel Prize in Stockholm, LTCM imploded. Its clients were wiped out and the reverberations of its collapse were felt globally. While its extensive use of leverage clearly played a role, it’s also clear that the strategy and the central assumption on which it was based had crumbled in the face of the August 1998 Russian debt default.
The metaphor of the turkey and its life-cycle in the run-up to Christmas day, as recounted by Nassim Taleb in his essay The Fourth Quadrant: A Map of the Limits of Statistics gives us a crucial insight into this dramatic collapse
"My classical metaphor: A turkey is fed for 1,000 days – every day confirms to its statistical department that the human race cares about its welfare 'with increased statistical significance'. On the 1,001st day (Christmas Day), the turkey has a surprise."
If the fate of the Turkey doesn't concern you, consider this quote from Titanic Capt EJ Smith on the eve of its only voyage: "When anyone asks me how I can best describe my experience in nearly 40 years at sea, I merely say, uneventful. Of course there have been winter gales, and storms and fog and the like. But, in all my experience, I have never been in any accident of any sort worth speaking about. I have seen but one vessel in distress in all my years at sea. I never saw a wreck and never have been wrecked nor was I ever in any predicament that threatened to end in disaster of any sort."
The story of the turkey in the run-up to Christmas Day and the Titanic captain in the run-up to launch is analogous to that of LTCM in the run-up to the Russian default.
In this month of anniversaries, the lesson from 15 years ago – that the only thing measured by historic volatility is historic volatility – needs recalling. Investors, regulators, banks, and their risk-managers, who continue to use it as a measure of risk are destined to suffer the fate of the turkey and Capt Smith. Try not to be among them.
John Looby is an investment manager at Setanta Asset Management, a global value manager based in Dublin. The views expressed are personal and do not necessarily reflect the views of his employer.