The story of how a “genius fund” almost caused a financial crisis

Few people remember now, but over 20 years ago, there was a bond-trading hedge fund which grew to over 100 billion from $0.

It was fun by PHDs, finance professionals and even two Noble prize winners.

The early signs were good. The returns were as high as 40% per year, beating the S&P500 and Dow Jones in the process.

Then things started to go wrong as the graph below shows:

LTCM had a very promising start but collapsed a few years later

By 1998 the firm had exposed some of America’s largest banks to more than $1 trillion in default risks.

Soon the fund lost most of its investors and the downturn was swift and sudden.

This unexpected turn of events was documented in the book by Robert Lowenstein.

So what does this episode show? More specifically it illustrates that:

  1. Intelligence isn’t a guarantee of superior investment returns for investors, nor are financial qualifications or even Noble prizes in finance. Charlie Munger, Bufett’s business partner, reacted to events like this with the quote below:

2. Regulation, and getting big, can be a very negative thing. Would the fund have collapsed if they didn’t get too big to fail? The Federal Reserve eventually stepped in, and just like the banks in 2008-2009, it did cause a moral hazard.

3. A lot of the risk models taught at universities and business schools are clearly not fit for purpose. That is one reason why more vanilla strategies have often beaten some of the complex investment decisions made by the likes of LTCM.

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