LTCM (and the *real* smart guys)

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

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

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."