Saturday, February 26, 2005

LTCM (and the *real* smart guys)

When Genius Failed : The Rise and Fall of Long-Term Capital Management

Inventing Money : The Story of Long-Term Capital Management and the Legends Behind It

Long Term Capital Management was the hedge fund founded (1994) by legendary Salomon bond trader John Meriwether together with Robert Merton and Myron Scholes, the Nobel prize-winning academics behind options pricing theory. Meriwether was one of the first on Wall St. to see the value of quants, building a talented team which he took to LTCM. After several years of superb returns (over 40% in one year), the fund blew up in the wake of the Russian debt default and had to be bailed out by a consortium of banks organized by the Fed (1998).

If you are interested in the details of the LTCM story, the two books listed above are the place to start. (There was also a lengthy article in RISK magazine years ago, but you'll have to dig that out of your library.) Lowenstein is a business writer (formerly of the WSJ), who has also written a nice biography of Warren Buffet. His treatment is more readable for the average person, although frustratingly short on the details necessary to understand LTCM's actual trades and positions. Dunbar was a grad student at Harvard in applied physics, so understands the technical details better. He even gives a nice history of derivatives and option pricing.

Central Bank of Volatility: One of LTCM's big trades was a bet that future realized vol would resemble historical vol. They did so much business that London equity derivatives traders nicknamed them the Central Bank of Volatility. Historical vol was about 15% for European markets, but in 1997 the implied vol was 23%. LTCM was willing to sell vol (long dated options) at that price. Even larger positions in fixed income and mortgage-backed securities were also based on the assumption that markets would approach equilibrium. The question, as always: how long before mean reversion? Can you stay solvent longer than the market can stay "irrational"?

In their case, the answer was no, but the consortium of banks that bailed them out (buying out their portfolio) eventually made money. There was an issue of LTCM's counterparties front-running them on trades, but I don't think this was the main reason for their demise, and ultimately their positions came back.

LTCM got all the press, but few people know that the single most successful investment fund in recent history is Renaissance Technologies, founded in 1988 by mathematician Jim Simons. (Physics readers may be familiar with so-called Chern-Simons theory (Simons was Chern's PhD student at Berkeley) and wonder "whatever happened to Simons?"). Renaissance has averaged annual returns over 35% since its inception, and employs mostly former physics and math PhDs (MBAs need not apply). If I recall correctly, they now have over $10B under management and one of the most aggressive fee structures in the business (5/44 instead of 2/20!?!).

Simons: "The advantage scientists bring into the game is less their mathematical or computational skills than their ability to think scientifically. They are less likely to accept an apparent winning strategy that might be a mere statistical fluke."


Anonymous said...

Now I am continually singing praises of model builders.


Anonymous said...

Important aside:

Thousands Died in Africa Yesterday

When a once-in-a-century natural disaster swept away the lives of more than 100,000 poor Asians last December, the developed world opened its hearts and its checkbooks. Yet when it comes to Africa, where hundreds of thousands of poor men, women and children die needlessly each year from preventable diseases, or unnatural disasters like civil wars, much of the developed world seems to have a heart of stone.

Not every African state is failing. Most are not. But the continent's most troubled regions - including Somalia and Sudan in the east, Congo in the center, Zimbabwe in the south and Ivory Coast, Liberia and Sierra Leone in the west - challenge not only our common humanity, but global security as well. The lethal combination of corrupt or destructive leaders, porous and unmonitored borders and rootless or hopeless young men has made some of these regions incubators of international terrorism and contagious diseases like AIDS. Others are sanctuaries for swindlers and drug traffickers whose victims can be found throughout the world.

In many of these places, poverty and unemployment and the desperation they spawn leave young men vulnerable to the lure of terrorist organizations, which, beyond offering two meals a day, also provide a target to vent their anger at rich societies, which they are led to believe view them with condescension and treat them with contempt. Training camps for Islamic extremists are now thought to be sprouting like anthills on the savanna.

'America is committed not only to the campaign against terrorism in a military sense, but the campaign against poverty, the campaign against illiteracy and ignorance.' Former Secretary of State Colin Powell said that. Well, America launched its war on terror after Sept. 11, but did not bother to look at some of the deeper causes of global instability. This country is going to spend more than $400 billion on the military this year, and another $100 billion or so for military operations in Iraq and Afghanistan. But that amount is never going to buy Americans peace if the government continues to spend an anemic $16 billion - the Pentagon budget is 25 times that size - in foreign aid that addresses the plight of the poorest of the world's poor....


Anonymous said...


A lot for me to digest in the couple of posts on the subject!

Anyway, a bonus of this blog is I get useful information on what some smart people who did phys/math are now up to :e.g., now I know what the S of CS is up to :)


BTW, I had a look at Klienert's book. I did not see has the closed-form solution for the Asian options you had arrived at (the classical BS European one is there). It will be a good h/w problem for your QFT students :)

Anonymous said...

Re Renaissance Technologies: 4 billion under management, founded 1982.

Steve Hsu said...

Hmm.. the date 1988 I just looked up. As I understand (these things can be closely guarded secrets), they may have been in the $4B size range for some time, but got a lot bigger in recent years like many other funds.

Also, most teams manage multiple funds (e.g., LCTM I, II, etc.), so to get total funds under mgmt you have to aggregate.

Anonymous said...

Steve, I was wondering if you could recommend an article that describes, simply, how the Chern Simons form is useful to physics.

Steve Hsu said...

This isn't entirely accesible to the non-specialist, but it gives the general flavor. Unfortunately this is a pretty specialized topic, so I don't know of *anything* written for non-physicists about Chern-Simons theory...

Anonymous said...

I am the anonymous post-er that requested info on chern simons above. I'm actually a physicist (grad student) but don't know any string theory. Do you know of an introductory paper to chern simons "physics" on the arxiv somewhere perhaps? Please don't go to any trouble, I was just wondering if you knew of one off-hand. It would just be interesting to know if this is useful to physics in a non-string theory way.

Steve Hsu said...

I still don't have a particular reference for you, but the most "physical" application of Chern-Simons is probably to gauge theory in 2+1 dims, where you can add a topological C-S term to the theory. I think people like Witten and Wilczek even tried to apply this to high-T_c superconductors (which are kind of planar, so might be effectively a 2+1 dim system) back in the late 80s or early 90s. I'm sure you can find these papers on SPIRES.

Sorry I don't have anything more specific.

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