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You should take a closer look at what actually happened to LTCM. Their model remained profitable even after the crash, and recovered value far quicker than othe

You should take a closer look at what actually happened to LTCM. Their model remained profitable even after the crash, and recovered value far quicker than other hedge funds did. The real cause of the systemic failure had more to do with the actions of investors than the fundamentals of the model. The investors were heavily overleveraged across the board, and when they started losing money elsewhere, they initiated a flight to liquidity within LTCM. The flight to liquidity caused them to liquidate positions before they converged, compounding losses. Those positions for the most part actually did converge, but were prematurely exited. Had those investors not liquidated, they would have continued making strong returns. In other words, LTCMs collapse was the fault of the investors in LTCM, not the fault of the model. There are hundreds of hedge funds that have continued using the same basic model as LTCM, and have lasted through two recessions and several global financial shocks. They have achieved that by learning from LTCM: keep the model, dump the stupidly overleveraged investors.

conistonwater 7y ago
I don't think that's right, at least this is not the way I learned it: the terms on which you borrow money to fund your investments should be considered a part of the model. So if you borrow short term and invest long term, your model itself now includes maturity transformation, and it can blow up just like any such model. Sure you can then construct a different model that's basically the same but without the maturity transformation, and that's okay, you'll get different returns. Thinking about it this way I think it's still fair to blame LTCM, their investors were free to do whatever their contract allowed them to do.
- owenversteeg 7y ago
  That's true, and very important. And while I think (or, at least, I hope) large investors keep that in mind after so many high profile explosions like LTCM, I think small time retail investors tend to forget that, and that there's a reason Vanguard (for example) suggests 70% stocks and 30% bonds. Doesn't seem too important, until you need the money...
SilasX 7y ago
>The flight to liquidity caused them to liquidate positions before they converged, compounding losses. But that wasn't some incidental thing; it indicated that the core idea behind their arbitrage was flawed -- that there is a reason that the more liquid (US) bonds were consistently overpriced: to account for the fact that, during the occasional crisis, investors flee to them!
listenallyall 7y ago
Not true. LTCM had some of the most restrictive covenants among similar funds. Minimum lockup of at least 2 years, and redemption notice of 3 or 6 months (hey its been 20 years) - in other words, if you wanted to redeem, you had to give multiple month notice. The investors had no way of forcing LTCM to liquidate any holdings in a panic, in fact the covenants were to protect against that exact scenario, so the firm could ride out their positions. Counterparties, on the other hand, very different story, if they didn't force LTCM'S hand, they would be stuck with an empty bag. You're correct that many of LTCM trades did eventually work out positively. But when you're driving a car at 200 mph, a mundane pothole is deadly. When your hedge fund levered 30x, a temporary liquidity crisis is also fatal.

conistonwater 7y ago

I don't think that's right, at least this is not the way I learned it: the terms on which you borrow money to fund your investments should be considered a part of the model. So if you borrow short term and invest long term, your model itself now includes maturity transformation, and it can blow up just like any such model. Sure you can then construct a different model that's basically the same but without the maturity transformation, and that's okay, you'll get different returns. Thinking about it this way I think it's still fair to blame LTCM, their investors were free to do whatever their contract allowed them to do.

owenversteeg 7y ago
That's true, and very important. And while I think (or, at least, I hope) large investors keep that in mind after so many high profile explosions like LTCM, I think small time retail investors tend to forget that, and that there's a reason Vanguard (for example) suggests 70% stocks and 30% bonds. Doesn't seem too important, until you need the money...

SilasX 7y ago

>The flight to liquidity caused them to liquidate positions before they converged, compounding losses. But that wasn't some incidental thing; it indicated that the core idea behind their arbitrage was flawed -- that there is a reason that the more liquid (US) bonds were consistently overpriced: to account for the fact that, during the occasional crisis, investors flee to them!

listenallyall 7y ago

Not true. LTCM had some of the most restrictive covenants among similar funds. Minimum lockup of at least 2 years, and redemption notice of 3 or 6 months (hey its been 20 years) - in other words, if you wanted to redeem, you had to give multiple month notice. The investors had no way of forcing LTCM to liquidate any holdings in a panic, in fact the covenants were to protect against that exact scenario, so the firm could ride out their positions. Counterparties, on the other hand, very different story, if they didn't force LTCM'S hand, they would be stuck with an empty bag. You're correct that many of LTCM trades did eventually work out positively. But when you're driving a car at 200 mph, a mundane pothole is deadly. When your hedge fund levered 30x, a temporary liquidity crisis is also fatal.