Hedge Fund Loss: 4 "Unscientific" Ways to Increase Your Total Returns

by Floyd Brown

Hedge Fund Loss: 4 "Unscientific" Ways to Increase Your Total Returns

by Floyd G. Brown, Advisory Panelist

Tuesday, April 15, 2008: Issue #784

In 1994, two Nobel Prize winners, along with other partners, founded Long-Term Capital Management (LTCM) L.P. in Greenwich, CT. The hedge fund was an immediate success, nearly tripling the money of its investors between its opening and late 1997.

The fund managers applied the scientific method to develop sophisticated arbitrage strategies that were "market-neutral." Using science, LTCM was supposed to make money whether stock prices were rising or falling.

Then came August 1998, and the best mechanisms that the scientific team could develop began to unravel. Long-Term Capital's portfolio saw its value fall 44%, giving it a 1998 year-to-date decline of 52%.

This translated into a hedge fund loss of almost $2 billion in a single month.

"August has been very painful for all of us," LTCM Chief Executive John W. Meriwether, the legendary Salomon Brothers bond trader, wrote at the time in a letter to investors. His words were clearly an understatement.

Fortunately, there are four simple rules you can follow to protect yourself against catastrophic losses - strategies that hedge fund LTCM certainly should have been following. Incidentally, these "unscientific" methods can also make you a heck of a lot of money...

Hedge Fund Loss Wipes Out LTCM

When the smoke cleared, the hedge fund loss had wiped out LTCM, and they lost $4.6 billion in just four months. LTCM had a negative net worth in the blink of an eye.

Its Nobel laureates, Robert H. Merton and Myron S. Scholes, as smart as they were, got crushed with other investors. Years later, the losses are hard to fully understand because Wall Street and the hedge fund world still haven't disclosed the extent of them.

The LTCM hedge fund losses didn't stop with LTCM shares. Nearly every major investment broker and bank in the United States paid a price when the scientists failed. Why?

Because most investment banks have proprietary trading departments that have their own scientists developing complex, computer-aided trading and hedging strategies.

In an announcement on September 2, 1998, Salomon Smith Barney Holdings disclosed that it had realized $300 million in losses from fixed income and global arbitrage-related credit losses. Then on September 9, 1998, Merrill Lynch & Co. announced that it had lost $135 million from trading.

Eventually the Federal Reserve Bank of New York organized a bailout fund of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets.

Does this story remind you of current market conditions?

If it doesn't, it should.

The LTCM house of cards was built on leverage, borrowing huge sums of money to make small amounts of money each month on the spread. Leverage was the key to the success in this arbitrage business. Their goal was to make money, not with their own capital, but with other people's money. Using the scientific method, these Ph.D.'s had believed they were prepared for any eventuality. Or were they?

Can The Scientific Method Evaluate Investments?

Unfortunately, the scientific method may not be the best way to evaluate investments. Let's go back to college for a quick refresher on the scientific method...

Frank Wolfs, Professor of Physics at the University of Rochester, provides his undergraduate physics students with a good working definition of the scientific method: "The process by which scientists, collectively and over time, endeavor to construct an accurate (that is, reliable, consistent and non-arbitrary) representation of the world."

Professor Wolfs, as a research scientist himself, understands some of its limitations:

"Recognizing that personal and cultural beliefs influence both our perceptions and our interpretations of natural phenomena, we aim through the use of standard procedures and criteria to minimize those influences when developing a theory. As a famous scientist once said, "Smart people (like smart lawyers) can come up with very good explanations for mistaken points of view." In summary, the scientific method attempts to minimize the influence of bias or prejudice in the experimenter when testing a hypothesis or a theory."

But under the high pressure of real-world Wall Street, which desires to make more money every quarter, can the formerly campus-bound academic scientists resist the psychological and cultural beliefs of their hedge fund partners and customers?

Apparently, evidence is slim that they have been able to do it...

Scientific Method Shortcuts On Wall Street

Walls Street has been known to shortcut the four essentials of the scientific method; here is a list of the essential steps in any experiment:

  • Observation and description of a phenomenon or group of phenomena.
  • Formulation of a hypothesis to explain the phenomena. (In finance, the hypothesis often takes the form of a mathematical relationship.)
  • Use of the hypothesis to predict other phenomena or to predict quantitatively the results of new observations.
  • Performance of experimental tests of the predictions by several independent experimenters.

Wall Street shortcuts these in a number of ways...

First, they start with a hypothesis, not observations or descriptions of phenomenon. It's pretty hard to observe a market for CDOs and subprime mortgage-backed securities when the market was basically created in the last decade.

So without any data, because there is no market functioning, the hedge funds and financial firms begin with a hypothesis. They can't even adequately back test the actual market, so they often insert a proxy to back test. Now if your proxy is a substitute for historical data with hypothetical data, you can see where a scientific model would be flawed. No wonder they have trouble predicting future market action. The experimental tests are in real time, using money borrowed from bank deposits.

4 Timeless Rules to Protect & Grow Your Portfolio

This discussion is not intended to scare you. It is intended to remind you of caveat emptor: "let the buyer beware." When your broker tells you he has a "sure, cannot lose" deal, be wary. Every market usually goes up and then comes down. I don't believe markets are overly efficient, and at times of distress, they are not even driven by the math.

So here's what to do...

Only invest in companies, securities and assets you understand. Don't be lured by get-rich-quick schemes, high-pressure sales methods, and the newest "silver bullet" for making a killing in the markets.

Instead, stick to the basics; they're profitable:

If you follow this simple advice, you will be wealthy beyond your dreams over the long run. These rules have been proven effective for decades, and you don't need a Ph.D. to understand them.

Good investing,

Floyd

Floyd Brown, a regular contributor to Investment U , began his highly successful investing career while still in high school... and made his first million before turning 30. Here are three companies Floyd's recommending right now.

comments powered by Disqus