September 30, 1998

An Investment Opinion
by Louis Corrigan

Long-Term Capital: Playing the Hand vs. Playing the Man

I want to play a slightly more abstract riff off Dale's excellent column yesterday on the Long-Term Capital hedge fund to get at what seems to me the fund's most basic mistake: misconstruing the nature of markets. But first, let's review the salient facts of the story as we know them.

First, Long-Term Capital was trading based on quantitative models designed by Robert Merton and Myron Scholes, recent winners of the Nobel prize in economics for an options pricing model that, among other things, helps translate a company's employee stock options into fully diluted shares. This quant approach takes years of historical data about how certain markets interact and pops out supposedly no-lose arbitrage plays where one takes advantage of pricing disparities between different investment instruments believed to have a predictable relationship to one another. Rather than making informed directional bets on how real-world economic and political events will play out, Long-Term Capital was generally making "market-neutral" bets based on algorithms that calculated probabilities and assumed equilibrium as the norm.

Second, as Dale noted, Long-Term produced woefully sorry results even in its best years considering that its extraordinary leverage should have made returns of 100% or more relatively easy to achieve. This year, investors have lost at least 90% of the money that remained in the fund and probably a lot more because many borrowed to raise their original investment equity and, more important, the fund was, in a fundamental way, insolvent prior to the "bailout."

Third, the 15 financial institutions that pumped $3.5 billion into Long-Term ultimately were not bailing out the fund -- they were bailing out themselves. If the fund's positions were summarily unwound, Long-Term would have less than nothing. That means that the various high-net-worth individuals who invested in the firm, including the Merrill Lynch executives who put in $20 million of their own money ($800,000 from Chair/CEO David Komansky alone), would walk away with nada. What's worse, the institutions that loaned Long-Term the money to make the highly leveraged bets would also take a hit. What's still worse is that Long-Term's selling, if done in a disorderly fashion, would create additional asset devaluations that would produce further shockwaves as others with leveraged positions got margin calls and the institutions that loaned them money also faced serious losses.

The Federal Reserve's concern for Long-Term Capital was simply a recognition that it presented a potentially massive systemic threat since its failure could lead to a virtual death-spiral of margin calls and liquidations. The Fed's involvement also suggests that Chairman Alan Greenspan was mistaken in believing that the largely unregulated hedge fund industry can be effectively controlled by regulating creditors. As we've seen time and again, creditors can be just as prone to greed as the latest wizard of Wall Street, but they're often the last to understand the risks that would ordinarily help fear counterbalance greed.

As Dale points out, Long-Term invested without an adequate appreciation of the specific risks it was accepting. How could anyone think it was reasonable to assume that historical market data was applicable to what proved an illiquid market for Russian debt? How can one adequately model for a complex array of factors that may each depart ever so slightly from what's considered statistically probable?

Ultimately, Long-Term's failure resulted from a misunderstanding of the basic nature of financial markets. Speculator George Soros, who pocketed a fortune making exactly the kinds of directional bets that Long-Term eschewed, insists that quantitative methods don't work because they are based on the erroneous belief that markets are always efficient. "I think that those methods work 99 percent of the time, but they break down 1 percent of the time," he said in Soros on Soros. "I am more concerned with that 1 percent. I see a certain systemic risk that cannot be encapsulated in those assumptions that generally assume a continuous market."

Markets embody two quite different characteristics. On the one hand, they experience long periods of apparent equilibrium whereby market participants appear to be processing fundamental information almost immediately and efficiently so that relationships seem predictable. On the other hand, markets experience boom/bust cycles, or extremes of disequilibrium, where the action seems irrational. Which state better defines the basic nature of markets? Ultimately, the latter, and that means that one should approach the market with a recognition of its capacity for discontinuity and fragility.

Soros comes to these views from a broader theory about the flawed nature of human understanding. We cannot ever see the world in itself but only through our interaction and participation in it. Indeed, markets don't really exist in themselves but only via our collective self-reflexive perception and repeated re-creation of them. In effect, disequilibrium enters a market not from the outside but from the imperfect understanding of the market's participants. Ironically, the very idea that equilibrium is the norm is itself part of what creates disequilibrium. Long-Term's reliance on probabilities offers shockingly direct support for Soros's theory. In effect, approaching a complex, adaptive system with methods analogous to Newtonian physics amounts to playing the game without understanding the rules. In other words, investors must have a proper respect for the market's fundamental instability in order to properly avoid or address specific risks.

A great example of this comes from the recent film Rounders, which is about poker players. The movie divides the game's risks into playing the hand (a matter of probabilities) and playing the man (a matter of intuition or judgment). The character played by John Turturro is said to be a "grinder." He doesn't aspire to the glory of the big score; he just wants to make a decent and consistent living playing cards. This is an admirable, profitable, though unspectacular approach that depends foremost on limiting one's opportunities for losing by avoiding games featuring superior players and always playing the probability of the cards. In a sense, Turturro begins by controlling the larger risks posed by the man and concentrates on playing the hand, folding when the cards are bad while raising his bets when the cards are good.

The narrative focuses on a character played by Matt Damon who is friendly with Turturro but aspires to greater glory and so must undergo some painful lessons in what the highest level of poker requires. Early on, Damon enters what is the film's equivalent of the Russian market and makes a huge bet based on the probabilities. But the probabilities fail him, as his Russian opponent's two aces beat his two kings. He's wiped out.

Success at this level requires that one play the man, since one's opponent is the greatest variable in the game. At one point, Damon says he could even play a hand blind, with no knowledge of the cards themselves. The cards, of course, aren't immaterial, and Damon learns when to cut his losses. But his principal challenge is to bring his judgment to bear in the way of a Soros, not just on the cards but on variables of the system that make it much more than a game of luck or even probability.

Extrapolating from poker to investing may be a stretch, but I think the Turturro character is analogous to a Foolish investor selecting an S&P index fund or a Dow Four approach. His greatest strength is recognizing his limitations and finding the most sensible and prosperous way to grind out a living considering those limitations. He misses the glory of the big score, but he still gets to hang out at the Turkish bath.

Damon's character lives in the world of more active portfolio management, which requires greater savvy because it entails greater risks. Probability is not ignored in this world, but it must always take a back seat to interpretation and judgment. In a sense, Long-Term Capital tried to apply a black box, grind-it-out approach based on probabilities to this world, where it confronted exactly the risks of disequilibrium it had begun by ignoring. In the visual language of Rounders, the managers at Long-Term simply didn't believe that something as ordinary and insignificant as a tray of Oreo cookies could have anything useful to tell them. Their fate was to watch their own cookies crumble.