Big Mistakes

by Michael Batnick

  His band of wizards would became the most powerful, profitable group inside of Salomon Brothers. In a year in which John Gutfreund, CEO, earned $3.5 million, Meriwether was reportedly paid $89 million.4 But after a scandal at the Treasury rocked the bank, Meriwether was forced to resign. Shortly thereafter, his loyal protégés would follow.

  Meriwether launched Long‐Term Capital Management with two giants of financial academia at his side, who would both later become Nobel Laureates. One was Robert Merton, who earned a bachelor of science in engineering mathematics from Columbia University, a master of science from the California Institute of Technology, and his doctorate in economics from MIT. Prior to joining Salomon Brothers, Merton taught at the MIT Sloan School of Management until 1988, before moving to Harvard University. His pedigree was flawless, and the influence Merton had on the world of finance cannot be overstated. Stan Jonas, a derivatives wizard once said, “Most everything else in finance has been a footnote on what Merton did in the 1970s.”5

  Meriwether was also able to recruit Myron Scholes, cocreator of the Black‐Scholes option pricing model. Scholes received his MBA and PhD at the University of Chicago Booth School of Business. He then went on to work at the MIT Sloan School of Management before coming back to teach at Chicago. It should be clear by now that the résumés at Long‐Term Capital Management were truly second to none. Nothing in finance had ever even come close. In a Fortune article, Carol Loomis said, “There may be more IQ points per square foot than in any other institution extant.”6 They were head and shoulders above everyone else and they knew it. Scholes once described themselves as “Not just a fund. We're a financial‐technology company.”7

  The minimum investment at LTCM was $10 million and their management fees were 2 and 25, above the standard industry practice of 2 and 20. The high minimum and above average fees did not deter investors. The smartest minds attracted the smartest and biggest clients, “including David Komansky, head of Merrill Lynch; Donald Marron, chief executive of Paine Webber; and James Cayne, chief executive of Bear Stearns.”8 They also took money from giant institutions like the Bank of Taiwan, the Kuwaiti pension fund, and the Hong Kong Land & Development Authority. Even Italy's central bank, which notoriously did not invest in hedge funds, forked over $100 million.9

  Long‐Term Capital Management opened their doors in February 1994 with $1.25 billion, the largest hedge fund opening ever up until that point in time. Their performance was strong right out of the gate. In the first 10 months that they were open, they earned 20%.10 In 1995, the fund returned 43%, and in 1996, they earned 41% in a year in which their profits totaled $2.1 billion:

  To put this number into perspective, this small band of traders, analysts, and researchers, unknown to the general public and employed in the most arcane and esoteric of businesses, earned more that year than McDonald's did selling hamburgers all over the world, more than Merrill Lynch, Disney, Xerox, American Express, Sears, Nike, Lucent, or Gillette—among the best‐run companies and best known brands in American business.11

  Long‐Term Capital Management was on a roll indeed. Their returns were high and steady, with their worst losing month being just a 2.9% decline.12 It seemed too good to be true. In the fall of 1997, Robert Merton and Myron Scholes both were awarded with the Nobel Prize in Economics. Of their achievement, The Economist wrote that they had turned “risk management from a guessing game into a science.” Their returns continued uninterrupted and they managed to quadruple their capital without having a single losing quarter.13

  But the good times would not last forever, because on Wall Street, such winning strategies tend to have a short half‐life. Big results breeds big envy, and eventually, every trading secret gets out. LTCM's arbitrage strategies were no exception. As Eric Rosenfeld, an LTCM trader, said, “Everyone else started catching up to us. We'd go to put on a trade, but when we started to nibble the opportunity would vanish.”14 Because opportunities were becoming harder to come by, at the end of 1997, after a 25% gain (17% net of fees), they made the decision to return $2.7 billion of capital to their original investors.15 They returned all the money that had been invested after 1994 as well as all of the investment profits made before that date.16

  This became problematic because the opportunities they sought were not large to begin with so their strategy required a ton of leverage. But when they returned $2.7 billion, they did not take down their position sizes, so their leverage went from 18:1 to 28:1.17 According to Loomis, LTCM wasn't planning to make a hefty return, and they believed the risk was low, but their leverage in both the United States and Europe soared. LTCM had about $40 million at stake for every point in volatility the markets moved.18

  At one point, they had $1.25 trillion in open positions and they were levered 100:1. This leverage would lead to one of the largest disappearing acts of wealth the world has ever seen.

  In May 1998, as the spreads between US and international bonds widened more than their models anticipated, Long‐Term lost 6.7%, their worst monthly decline up until that point. In June, the fund fell another 10%, and they were staring down the barrel of a 14% decline for the first half of the year. Russia was at the epicenter of Long‐Term's downward spiral, and in August 1998, as oil – their main export – fell by one‐third and Russian stocks were down by 75% for the year, short‐term interest rates skyrocketed to 200%. And then the wheels fell off for Meriwether and his colleagues. All the brains in the world couldn't save them from what was coming.

  LTCM took financial science to its extreme – to the outer limits of sanity. They coldly calculated the odds of every wiggle for every position in their portfolio. In August 1998, they calculated that their daily VAR, or value at risk (how much they could lose), was $35 million. August 21, 1998, is the day when their faith should have evaporated, along with the $550 million that they lost.19 It was the beginning of the end.

  By the end of the month, they had lost $1.9 billion, putting the fund down 52% year‐to‐date. The death spiral was in full effect. “On Thursday September 10, the firm had lost $530 million; on Friday, $120 million. The next week it hadn't stopped: on Monday, Long‐Term dropped $55 million; on Tuesday, $87 million. Wednesday, September 16, was especially bad: $122 million. Like a biblical plague, the losses gave no respite.”20 On Monday, September 21, they lost $553 million.21

  In the end, in an effort to prevent their failed positions from poisoning the entire financial system, the Federal Reserve Bank of New York would orchestrate a 90%, $3.6 billion takeover, led by 14 Wall Street banks. The fall of Long‐Term Capital Management was on a scale the industry had never before witnessed. It was two and a half times as big as Fidelity's Magellan Fund, and four times as big as the next largest hedge fund.22 Their fund had $3.6 billion in capital, of which two‐fifths was personally theirs. In five weeks, it was gone.

  How could smart people possibly be so stupid? Their biggest mistake was trusting that their models could capture how humans would behave when money and serotonin are simultaneously exploding. Peter Rosenthal, Long‐Term's press spokesman once said, “Risk is a function of volatility. These things are quantifiable.”23 There is a lot of truth in this; after all, at their peak in April 1998, $1 invested turned into $2.85, a 185% profit in just 50 months! But Nassim Taleb, in Fooled by Randomness, was also right when he said, “They made absolutely no allowance in the episode of LTCM for the possibility of their not understanding markets and their methods being wrong.”24

  Jim Cramer said, “In short, this was a seminal blowup. It struck at the heart of all of those on Wall Street who think that this racket is a science that can be measured, structured, derived and gamed.”25

  They were able to calculate the odds of everything, but they understood the possibility of nothing. The lesson us mere mortals can learn from this seminal blowup is obvious: Intelligence combined with overconfidence is a dangerous recipe when it comes to the markets.

  Notes

  1. Patricia K. Cross, “Not Can, But Will C
ollege Teaching Be Improved?,” New Directions for Higher Education 17 (1977): 1–15.

  2. Charles D. Ellis, “The Loser's Game,” Financial Analysts Journal 31, no. 4 (July/August 1975): 19–26.

  3. Michael Lewis, “How the Eggheads Cracked,” New York Times Magazine, January 24, 1999.

  4. Janet Lowe, Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger (New York: Wiley, 2000), 194.

  5. Roger Lowenstein, When Genius Failed (New York: Random House, 2000, 29.

  6. Carol Loomis, “A House Built on Sand,” Fortune, October 26, 1998.

  7. Lowenstein, When Genius Failed, 65.

  8. Edward Chancellor, Devil Take the Hindmost (New York: Penguin, 1999), 339.

  9. Lowenstein, When Genius Failed.

  10. Loomis, “A House Built on Sand.”

  11. Lowenstein, When Genius Failed, 94.

  12. Ibid., 127.

  13. Roger Lowenstein, “Long‐Term Capital Management: It's a Short‐Term Memory,” New York Times, September 7, 2008.

  14. Lewis, “How the Eggheads Cracked.”

  15. Chancellor, Devil Take the Hindmost, 339.

  16. Peter Truell, “Fallen Star Manager,” New York Times, September 9, 1998.

  17. Lowenstein, When Genius Failed, 120.

  18. Ibid., 126.

  19. Lowenstein, “Long‐Term Capital Management.”

  20. Lowenstein, When Genius Failed, 180.

  21. Ibid., 192.

  22. Ibid., 80.

  23. Quoted in Lowenstein, When Genius Failed, 64.

  24. Nassim Taleb, Fooled by Randomness (New York: Random House, 2004), 242.

  25. Jim Cramer, “Einstein Has Left the Building,” TheStreet.com, September 3, 1998.

  CHAPTER 5

  Jack Bogle

  Find What Works for You

  Sometimes in life, we make the greatest forward progress by going backward.

  —Jack Bogle

  The Vanguard 500 Index fund is the world's largest mutual fund, with $292 billion in assets. That's 292 followed by nine zeros. How do you get to be so gigantic? Start with $11 million and grow 29% per year for the past 40 years. To give you an idea of how much money $292 billion is, if you were to stack it in hundred dollar bills, it would stretch 198 miles, which is just about the round‐trip distance from New York City to Vanguard's headquarters in Valley Forge, Pennsylvania.

  Index funds have picked up incredible momentum in the past few years. Since the end of 2006, active investors have pulled $1.2 trillion from active mutual funds and plowed $1.4 trillion into index funds.1 Vanguard has been the biggest beneficiary of the tidal wave of change of investor preference. The only mutually owned mutual fund structure in the world, Vanguard had the largest sales ever by a fund company in 2014, in 2015, and again in 2016.2 But despite the ubiquity of index funds today, it was not always this way. The idea that investors should settle for “average” returns was once heresy and these funds were often referred to as Bogle's folly.

  The effect that Jack Bogle has had on the mutual fund industry and on all of finance cannot be overstated. Vanguard is now ubiquitous, managing more than $4 trillion in client assets. But the idea of capturing “just” market returns, however, was not something that took off right away. In fact, the index fund was met with resentment from the investment community and apathy from investors. The goal for Vanguard's underwriting of the First Index Trust in 1976 was $150 million. When all was said and done, they raised just $11.3 million, a 93% shortfall from their desired target.3

  The lesson we can learn from one of the most influential investors of all‐time is that investing is a long journey, often lasting a lifetime. It is filled with success, failure, hopes, dreams and everything in‐between. Jack Bogle is on the Mount Rushmore of investing, and what he will be remembered for, the index fund, was something that he didn't create until three years shy of his 50th birthday!

  Twenty‐five years before the index fund was created, in his 1951 thesis at Princeton University, Bogle wrote mutual funds “should make no claim to superiority over the market averages.” He studied the recent performance of mutual funds and discovered that they trailed the index by 1.6% each year. Later that year, Walter Morgan, a Princeton alum and the founder of the Wellington Fund, hired him. Morgan created one of the first actively managed balanced mutual funds in 1928, with $100,000 (originally under the name The Industrial and Power Securities Company). Almost 90 years later, it is the oldest balanced fund in the United States. The Wellington Fund was one of the few funds to survive the Great Depression, which it owes to the prudence of its founder. The fund had 38% of its assets in cash heading into the crash of 1929. Viewed as a responsible steward of capital, Wellington would gain momentum throughout the Great Depression as many of its competitors fell by the wayside.

  When Bogle was hired in 1951, the Wellington Fund managed $140 million. Today, at $95 billion, its assets have grown by 95,000,000%, or just under 17% a year for the past 89 years. But the journey between then and now was hardly a smooth ride.

  In 1964, just before its assets would peak at $2 billion, Walter Morgan said, “The name Wellington had a magical ring, a sort of indefinable air of quality about it that made it almost perfect as a name for a conservative financial organization.” The conservative financial organization would quickly lose its way. Performance sputtered, the dividend declined, and fund assets cratered to $470 million, a 75% collapse!4

  The fall from grace happened under Bogle's watch. He was a member of the investment committee from 1960 to 1966, and in 1965, at just 36 years old, he was handpicked by Morgan to succeed him as the president of the Wellington Group and in 1970, he was named CEO.

  Performance first started to fall behind as Bogle's responsibilities grew. From 1963 to 1966, the flagship Wellington Fund gained just 5.1% annually, well below the 9.3% return of the average balanced fund.5 As the environment started to heat up and the conservative nature of Wall Street was transformed by the first generation of new blood to enter since the 1920s, management decided it needed to do something to keep up with the changing times. “Lured by the siren song of the Go‐Go years, I too mindlessly jumped on the bandwagon.”6

  Their decision to keep up with the times led them to merge with a young Boston firm, Thorndike, Doran, Paine & Lewis Inc. Bogle said the move was designed to achieve three goals:

  Bring in managers from the “new era” who could return their performance into top results

  Bring a new speculative growth fund (Ivest Fund) under the Wellington banner.

  They wanted to gain access into the “rapidly growing investment counseling business.”7

  The merger of these two companies was an odd pairing; it would be like Vanguard purchasing a crypto‐currency trading firm today. The following is an excerpt from The Whiz Kids Take Over, an article that appeared in Institutional Investor in 1968: “Wellington was founded in 1928 with a balanced portfolio of common and preferred stocks and high‐grade bonds, with the objective of providing investors with stability, income, and a little low‐risk growth to keep pace with inflation…Ivest, on the other hand, was established in 1961, in effect, to make the most of those very fluctuations that Wellington was originally designed to minimize.”8

  The merger turned the Wellington Fund into the antithesis of what led to its long‐standing success. From 1929 to 1965, Wellington's equity ratio averaged 62% and its beta averaged 0.6.9 But with the new kids in town, turnover went from 15% in 1966 to 25% the next year, and stocks, which averaged 55% for a balanced fund, approached 80%.

  Shortly after the merger, Bogle was feeling pretty smart about their shrewd business decision. In a recent interview, he said, “The first five years you would have described Bogle as a genius. And at the end of the first 10 years, roughly, you would have said: the worst merger in history, including AOL and Time Warner. It all fell apart. Their management skills were zero. They ruined the fund they started, Ivest. They started two more and ruined both. A
nd they ruined Wellington Fund.”10

  Like so many other funds, Wellington got seduced and ultimately chewed up and spit out by the go‐go years of the 1960s:

  The term “go‐go” came to designate a method of operating in the stock market – a method that was, to be sure, free, fast, and lively, and certainly in some cases attended by joy, merriment and hubbub. The method was characterized by rapid in‐and‐out trading of huge blocks of stock, with an eye to large profits taken very quickly, and the term was used specifically to apply to the operation of certain mutual funds, none of which had previously operated in anything like such a free, fast, or lively manner.11

  Investors found out how their “balanced fund” would be transformed into something completely unrecognizable in the 1967 annual report. Walter Cabot, the new portfolio manager, wrote:

  Times change. We decided we too should change to bring the portfolio more into line with modern concepts and opportunities. We have chosen “dynamic conservatism” as our philosophy, with emphasis on companies that demonstrate the ability to meet, shape and profit from change. [We have] increased our stock position from 64 percent of resources to 72 percent, with a definite emphasis on growth stocks and a reduction in traditional basic industries…. A strong offense is the best defense.12

  This was written as the go‐go years were approaching their apex, the timing could not have been worse. John Dennis Brown, author of 101 Years on Wall Street, described 1968 as “the most speculative year since 1929.”

  The go‐go years came to a bloody ending in 1969, with the Dow falling 36% in 18 months and individual issues falling much farther. But the stock market bounced back, and the bloody memories were quickly erased in investors' minds. The next things to take hold on Wall Street were the nifty fifty and the “one‐decision” stocks. Portfolio managers would no longer rapidly trade these growth stocks, instead they would invest in blue chips like IBM and Disney, and no price was too rich.