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The writer is founder of Elm Wealth, a former founding partner of Long-Term Capital Management and co-author of ‘The Missing Billionaires: A Guide to Better Financial Decisions’
Since Long-Term Capital Management’s collapse 25 years ago this month, the story of the hedge fund’s fall from grace continues to echo through markets and the financial world.
LTCM’s trading decisions and the personalities involved have been amply discussed in multiple books, articles and even business school case studies. But one question merits more discussion: how should an LTCM partner, for example myself, have decided how much to invest in the fund we managed?
The decision on how much “skin in the game” is right for you is faced by anyone who can invest in the business they work for. Naturally, people who are betting on you like to see you “eating your own cooking”, but that should not distract you from first answering the question of what is best for you.
LTCM got going in 1994 with $1bn of funding, the largest hedge fund launch at the time. Believers were not disappointed, as we generated 31 per cent annual net returns in our first four years, with moderate realised risk. Winning months outnumbered losing ones four-to-one, and the fund had not lost money two months in a row.
Then in late 1998, LTCM suffered losses of more than 90 per cent. At the urging of the New York Federal Reserve, a consortium of 14 large banks invested $3.6bn in the fund for a 90 per cent ownership interest.
The fund was liquidated in a year, at a profit for the banks. A much-debated dividend to outside investors in 1997 gave them a median life-to-date return of 19 per cent a year, including the 1998 losses.
LTCM made a small net profit over its life, but unfortunately for the partners such as me, the 1998 losses virtually wiped out our personal investments in the fund.
Until late 1998, I thought the fund was a very attractive investment. As a senior trading partner, I had a full picture — including the rationale — of everything the fund was investing in.
From our years of prior trading experience at Salomon Brothers, the LTCM founders recognised that the fund’s returns, like most financial assets, had “fat tails” — the risk of outsized losses was much greater than you would expect from a normal distribution of returns.
We knew that almost all our trades were positively correlated with each other and would be more correlated in a crisis. We traded through the crash of October 1987, and understood that financial risk is magnified by feedback loops, where asset sales triggered by price falls can beget more sales and further declines.
Still, I had wanted to invest personally in the fund, but how much? I realised later that I did not have a good framework for answering this question. Ultimately, I decided that no matter how attractive the investment opportunity, I would keep an amount on the side invested safely, so that whatever happened I would be OK.
I decided to keep apart 20 per cent of my liquid net worth, which excluded my home and my illiquid ownership interest in the LTCM management company. Of course, had I known the fate of LTCM, I would not have invested anything in the fund. But, given what I knew at the time, what should I have decided?
Critically, I should have included my ownership in the management company as a large part, more than 50 per cent, of my total assets. It was risky, and more importantly, a large loss in the fund would likely wipe out its value and put a big dent in my “human capital” too. If I had used a framework that explicitly modelled my personal risk aversion and applied it to my entire balance sheet, I think I would have decided to put about 50 per cent of my liquid capital in the fund, rather than the 80 per cent I did invest.
Commenting on LTCM in October 1998, Warren Buffett said: “But to make money they didn’t have and didn’t need, they risked what they did have and did need.” Buffett tells us we should never risk everything, and in my personal case I did not, but he does not say exactly how much we should put at risk when faced with an attractive opportunity.
A framework that focuses on expected risk-adjusted return, or what economists call “expected utility”, provides this missing guidance. The LTCM experience is a poignant reminder that getting the sizing of one’s investments right, particularly when they involve “skin in the game”, can be more critical than identifying attractive investments.
Most of the LTCM trades were attractive. Unfortunately for the LTCM investors and partners, our decisions on the size of the trades divorced us from their eventual profitability.
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