Lesson's From Famous Investor Collapses

With the Corona Virus starting to take a toll on markets and investors many equity investors starting to feel some pain in their portfolio, I’ve been focusing my thoughts on some of the more famous collapses of many professional investors.

Let’s start with the collapse of Long Term Capital Management, founded by the engine room and brains (many of the traders and partners were academics including Nobel Prize winners) of the 1980’s behemoth that was Salomon Brothers.

The firm invested heavily across all markets but had a particular affinity for trading Treasury Arbitrage. The strategy involves taking a long position on an older treasury and a short position on a freshly issues treasury to take advantage of the price discrepancy that often occurs between new issues and slightly older issues. Over time, it is assumed that prices will converge as even newer issues are released to the market.

The firm was incredibly reliant on their mathematical models and due to their conviction in these models they were willing to use extreme leverage. During the initial 3 years of the fund’s existence, the returns were incredible with after fee performance being 21%, 43% and 41% respectively.

However, the Russian Currency Crisis of 1998 lead investors to flooding to quality resulting in demand for the most liquid treasuries driving the prices up significantly. Despite holding 1000’s of positions because of the underlying similarity on the holdings, the leverage used and a sudden lack of liquidity resulted in the firm suffering catastrophic losses and a $3.6 Billion bailout by LTCM’s biggest counterparties.

The lessons available here are:

1.      Leverage is like fire. Well managed it will keep you warm but if you take your eyes off it for a minute it will burn your house down

2.      Diversification works but when all your positions are focusing on the same ideas and are correlated the benefit of the diversification is dulled

3.      Liquidity is plentiful during a bull market, during a crisis liquidity evaporates quicker than hot water

4.      When investing, even the smartest people and models are not accurate 100% of the time. The models that LTCM relied on did account for either liquidity, flock to safety and most importantly fat tailed distributions of data in financial markets.

Maintaining our 1990’s theme, let’s talk about the eventual closure of Tiger Management founded by arguably one of the greatest hedge fund managers of all time Julian Robertson. Robertson, was famous for being very public about his largest positions and being willing to make very concentrated bets.

Growing from a starting capital of $8 million, to a peak of $22 Billion, Robertson was one of first generation of superstar hedge fund managers. However, a combination of a highly concentrated bet on US Airways, the unpopularity of value investing in the late 1990’s and a huge bet on the Japanese Yen resulted in Robertson deciding to close his fund.

Lesson’s learnt here are:

1.      Losing a whopping $2,000,000,000 in a day in a currency trade involving the Japanese Yen highlights the risk of straying outside of your circle of competence. A traditional value investor, Robertson was certainly dancing outside of his wheelhouse with this position

2.      Owning significant portions of company’s and the world knowing it can result in an inability to escape a position. Once again liquidity disappears during a crisis.

Moving onto the mid 2000’s I could mention the numerous funds and even investment banks that closed as a result of GFC related losses (i.e Bear Sterns as a result of terrible mortgage backed securities trades), however the fund closure that resonates the most with me is the closure of Amaranth Advisors. Founded as a part of the early 2000’s multi strategy hedge fund boom, Amaranth in theory was a diversified multi asset fund, in effect however by it’s closure to was effectively an $8 Billion Natural Gas speculation fund.

Trader Nick Hunter, effectively became the sole buyer of natural gas spreads (the price difference between one months gas price and another months) and due to the sheer volume of his buying he was able to move prices in his direction for a surprisingly long time. In fact it is rumoured that in April 2007 he made over $1 Billion for the month trading the dreaded widow maker spread.

However, like Icarus and his wings, flying too close to the sun will cause you to fall, Hunter and Amaranth suffered a rapid demise when a combination of a warm winter, a better than expected hurricane season and the size of his own trades all turned against him. Leading to a rapid demise and eventual shutdown of Amaranth.

The take away’s here:

1.      Over concentration in any position or market will destroy liquidity over time.

2.      When a big fish gets trapped in a small pond, often it is the little fish that walk away with the winners.

3.      Due to the majority of Hunter’s positions being traded with margin, as before when trading with margin it is essential to remember that not only are your rewards amplified but your so are your potential losses.

After writing this it almost, just almost, makes me not want to invest anymore. If some of the most intelligent investors of all time can suffer tremendous losses, what chance does the every day investor have?

In my opinion, the small investor actually has tremendous advantages coming from their lack of size. For example when trading $10,000 blocks of shares liquidity is typically not an issue. Additionally, you are able to invest in much small companies or offerings and move the needle on your portfolio.

One parting piece of wisdom, is as we have seen this week, stay away from leveraged positions unless you have more that sufficient capital for your worst expected draw down plus 25% (got to have a margin of safety of course).