25 years ago this month, catastrophic losses at the hedge fund Long-Term Capital Management, or LTCM, almost brought the entire financial system to its knees. The story has been told many times, but always by outsiders. On the latest episode of The Investing Show, one of LTCM’s founding partners, VICTOR HAGHANI, recalls events from an insider’s point of view.
Victor has been on a fascinating journey since then, intellectually and professionally. He is now a passionate advocate of low-cost, buy-and-hold indexing for the vast majority of investors.
It’s an extraordinary story, and one that every investor can learn from.
Robin Powell: Hello Abraham, we’ve got a fascinating story for you this week.
Abraham Okusanya: I’m intrigued Robin, what story is that?
Robin Powell: Well, it’s the cautionary tale of the hedge fund Long Term Capital Management, which collapsed 25 years ago.
Abraham Okusanya: Ah yes, LTCM. A crisis that almost brought the entire financial system to its knees.
Robin Powell: That’s right. LTCM was conceived by some very clever people, and I’ve been speaking to one of them. He’s Victor Haghani, a former banker and then a very successful trader. He was one of the fund’s founding partners. We’ll hear from Victor in a moment, but first, let’s look at the background.
Long-Term Capital Management launched in 1994, the brainchild of a group of prominent academics, including two Nobel Laureates. Between them, they developed sophisticated mathematical models based on historical market behaviour for pricing options and managing risk. For a time, LTCM generated large profits and attracted sizable investments from institutions and wealthy investors. Victor Haghani invested 80% of his family’s wealth in the fund – a decision he came to regret.
Victor Haghani: LTCM has always been written about from the outside, rather than from the perspective of a partner of LTCM. And the outside perspective has had plenty of coverage: I’m not trying to rehash any of that at all. I’m just saying – for me, personally – how should I have behaved with a more coherent framework of thinking about return and risk? So, really I thought that LTCM was this great investment. It had a small chance of something really bad happening – how should I have factored in that small chance of something bad happening? It wasn’t that I didn’t think there was a small chance – it was just that the way that I went about assessing that for my own family’s investing, I think, was wrong and wasn’t logical and and rational. If I had a chance to do it again, I would still have invested a lot in the LTCM fund, but just not as much. If I had the whole thing to do over again, we would make sure that LTCM itself didn’t lose all that money. But I think that’s asking a little bit too much from hindsight!
Robin Powell: A series of unforeseen events in the summer of 1998 – notably Russia defaulting on its debt – resulted in huge losses for the fund. So when did Victor start to realise that things were going badly wrong?
Victor Haghani: Everything came to a head in the September of 1998. But, over the summer in July, we were already seeing very, very worrying signs; and we were starting to reduce our positions at that point; and starting to try to raise more capital from what we thought were a lot of investors that had wanted to invest in LTCM.
One of the strong causes of the unravelling was that LTCM had been doing very well, and now there were a bunch of other pools of capital that were doing similar things. There was obviously the pool of capital at Salomon Brothers that was now part of Citi that was doing the same things because we were all a family together. There were people at Goldman doing the same thing; there were people at other hedge funds doing the same thing; at other banks doing the same thing; at Credit Suisse doing the same thing. And as markets were starting to get a little bit roiled by events in Russia and elsewhere, the Citibank – the Citi Group – president Jamie Dimon went and started to shut down all the proprietary trading at Citi. You know, these were our kind of cousins and family members that we left behind when we set up LTCM. So they started to liquidate and that started to get things… now we started to see this behaviour in the market that, with the benefit of hindsight, you could really see was this building crescendo. And then everybody – us, Goldman, everybody – started to try to reduce positions as that was happening.
But, if we were all reducing positions, there was really nobody else left. There weren’t a lot of other people out there looking to put these positions on that wasn’t already involved in the activity. And then as I say: in our case, we went out and tried to raise more outside capital from existing and other investors that had wanted to invest in LTCM – but it was sort of a race against the clock and and it didn’t work out. I think that we were close but anyway – a brief answer to your question is: it was pretty clear in the summer of ’98 that all was not well.
Robin Powell: Eventually the market reaction threatened not just LTCM survival, but the stability of the whole financial system. A much bigger crisis was only narrowly averted when a consortium of banks and other major institutions stepped in to bail the fund out. Investors who had invested too late in LTCM suffered large losses. Thankfully, most investors had been in the fund from the start.
Victor Haghani: What you needed to do was to invest early and then take money out, and so – most of our investors that had invested in the first one or two years – we forced a dividend to them in 1997. So, you know, most of our investors did quite well from their investment with us because we forced this dividend that they weren’t happy about at the time. With the benefit of hindsight, we obviously wish we hadn’t done that and had maintained more capital. I think that chastening is a good starting word for what the experience was like.
A little bit of an understatement. You know, it was really painful. It was just like getting knocked out by a very blunt instrument with a heavy blow. And it really took a while to recover from that. When I think about this sort of recovery process, from a personal point of view, time heals all wounds as they say; but also I think that the friendships and the closeness among the partners persisted. You know, misery loves company. It certainly was a terrible experience to go through, but it was made much more bearable by sharing it across the shoulders of most of our partnership and we remain friends. Most of us remain friends and close to this day, 25 years later.
Robin Powell: But the story doesn’t end there. The LTCM saga prompted Victor Haghani to look afresh at investing and, over the next few years, his investment philosophy changed completely.
Victor Haghani: So I got to this point and I was like, wow! I really need to focus on investing the remaining capital and savings of my family post-LTCM, and I kind of realised that, “wow, I’ve never really thought about personal investing at all.” you know, here I was almost 40 years old and I had never really thought about it. I was working in at the forefront of finance, but I never really thought about personal investing. When I was at Solomon Brothers, I was young, I was getting paid. They were putting half of my compensation into Solomon stock, and the rest of it, I would pay tax on and sort of just keep mostly in cash and not do much investing. Then at LTCM, it just seemed like the only thing to do with your money was mostly put it into the LTCM fund. That seemed like the thing to do.
So I wasn’t really thinking about investing. Yet all of a sudden here I was. So the first thing that I did is I looked around at people that I respected, people that I liked, and I looked at what they were doing. All of them were actively trying to beat the market through different kinds of alternative and private investments, and angel investing, and doing trading in their own accounts – almost to a man, to a woman. And so I decided that’s what I should do too. You know, I knew all these hedge fund managers. It was my world. I thought I could assess managers. I thought I could find good investments, and that it would be fun. And so that’s what I started to do.
So I did that for four or five years. And then one day – maybe around 2005-06, I just started to really take stock of what I was doing and what my life was like. I was spending so much time on it. I was paying so much in fees. And also as a taxable investor, I saw that what I was doing was highly tax inefficient as well: a lot of short-term capital gains, a lot of ordinary income, a lot of non-deductible business expenses for the US listeners. And so I sort of decided I really wanted to go back to basics and to start to move away from all these active, concentrated forms of risk and get to what I was taught when I went to the London School of Economics: invest in the market portfolio, get full diversification, be a long-term investor. And that started my different journey after working in an investment bank, in a hedge fund. Started, I guess, the third chapter of my relationship with finance.
Robin Powell: Well, Abraham, we’re going to be looking more closely in the next episode at Victor Haghani’s views on low cost index investing, which he says is how most people should invest. We’ll also discuss his new book, The Missing Billionaires. But what did you make of his recollections of the LTCM collapse?
Abraham Okusanya: I am always fascinated by these road to Damascus experiences that many index investors go through. It often starts with an intelligent and capable person who thinks they can outsmart the market, which invariably ends in disappointment and humiliation. That forces you to re-examine the extensive evidence about investing, and you come to the realisation of the fact that – whatever your strategy, however smart you think it is – beating the market on a consistent basis is a very, very hard thing to sustain in the long term. And that’s exactly what Victor’s story tells us.
Robin Powell: There are so many lessons to learn from this saga, aren’t there? One of the most frightening ones is how quickly contagion can spread, especially when there are so many active managers pursuing very similar strategies.
Abraham Okusanya: Yes, this is a point we’ve made on this show before – and recently in fact – about how groupthink in the investment market or investment management industry means that, even for a successful fund or strategy, you can very quickly become a victim of your own success because others will pile in. They will copy you and they will try to do what you’re doing. And the reality is that – very, very quickly – that erodes what may seem, at the time, like genius; and it may well very, very quickly end up looking stupid or reckless.
Robin Powell: Now the Russian debt default in 1998 is a classic example of a black swan, an unforeseen and rare event with significant consequences. Rather like the COVID pandemic, or the crisis in mortgage-backed securities in 2008. As investors, we have to expect the unexpected, don’t we?
Abraham Okusanya: Absolutely. We need to accept that there are risks lurking around the global financial system. The tool we have, as index investors, is that we are investing in a globally diversified portfolio of companies. And that strategy will almost always work better than an actively managed strategy that is trying to do sophisticated things, or trying to shift your portfolio one way or the other, because – by its very definitions – when these black swan events do come around, do show up, our policymakers and our governments and our central banks – they rise up to the occasion and, so far from all of the experiences that we’ve seen, they avert these crises. There’s no shortage of people who will claim that they can foresee these risks and avoid them by creating a sophisticated strategy or by shifting your portfolio one way or the other. The reality is that most of them fail. They don’t work.
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