A List for Long Term Capital Management
By Paul Copeland
AUGUST 1998 was the 3rd worst month for stocks in the last 50 years, with the market down almost 14.5%. This was an even bigger drop than in March 2020, when Covid sank the S&P 500 12.5%.
Many people don’t remember the summer/ fall of 98, but I certainly do. I had just moved to Boston after spending a few years in Japan and thought I would have a job with MFS Investment Management (this is the firm that created America’s first mutual fund). The crisis that dropped the market put them and several other financial firms in a hiring freeze. So, I had to re-start my job search and on August 31st had an interview with traders at Bear Stearns. As we met that afternoon, the TV news reports were blaring that the Dow was down over 500 points (down 6.4% or about 2,100 points in today’s figures). Their upper floor of a Boston skyscraper was crazy and both I and the guys interviewing me knew it wasn’t a fit for me.
The big news was that Russia had defaulted on its’ debt. Behind the scenes though, it was much more complicated. The largest, most powerful hedge fund that everyone on Wall Street had been hustling for years to maximize business with, was imploding. In the good years, Bear Stearns had been “lucky” enough to beat out Merrill Lynch and others to be the clearing broker, taking responsibility for the trades of the now sinking hedge fund. Long-Term Capital Management (LTCM) was this hedge fund, started by John Meriwether, the legendary head of Solomon Brothers’ bond arbitrage desk. The bond traders who joined Meriwether were the smartest in the industry, earning the nickname “Young Professors.” They included two Nobel Prize winning economists, Robert Merton & Myron Scholes, who wrote the textbook formula to price options. This formula was an important part of the Chartered Financial Analyst derivatives curriculum that I studied, and my lecturers considered it a masterpiece. LTCM’s specialty was finding pairs of bonds that had a predictable range between their prices. When bonds were trading outside of that range, they bet that the prices would converge (or return to normal).
Their returns were over 20% in the first year and over 40% in each of the following 2 years. But to make more money they had to take big bets, using leverage. In other words, most of their investments were made with borrowed funds. Just before their fall they had $5 billion of equity and $125 billion of debt. Fortune Magazine wrote “At LTCM the best minds were destroyed by the oldest and most famously addictive drug in finance, leverage.” They also chased returns into areas where they didn’t have a competitive advantage or even much expertise, including currencies, equities, and emerging market sovereign debt, such as the Russian bonds that defaulted.
Ironically, the stock market finished up 27% for the year 1998 as seen in the first chart, but LTCM was wiped out that fall. On September 10th, Bear Stearns threatened to stop clearing LTCM trades because they feared being on the hook if LTCM went bankrupt. Less than a month after my job interview, the CEO of Bear Stearns declined to participate with 14 of the largest financial institutions in a Federal Reserve bailout of Long-Term Capital Management. 10 years later, in the Great Recession of 2008, Bear Stearns collapsed, brought down by collateralized debt obligations (CDOs), an asset with risks they didn’t understand. The Federal Reserve brokered a fire sale of their assets to JP Morgan.
LTCM and Bear Stearns were led by some of the best and brightest. They had connections, capital, degrees and expertise but they failed partly by going away from what they knew. It’s easy to do as there are so many investment opportunities out there. Mutual funds alone number over 100,000 worldwide. There is a finite number of investments that any one firm can follow, so an approved list of investments is a helpful tool to keep us from getting lost in unknown areas.
We choose to focus on what we know
Unless otherwise directed by the account owner, we only purchase stocks or funds that are on our approved list. Our Trust Investment Committee, consisting of 10 investment professionals, currently follows about eighty Mutual Funds and Exchange Traded Funds (ETFs), along with 215 individual stocks. Since we customize portfolios for our clients, we keep this larger list to have options in each of the 11 major industry sectors that we use toward certain goals of some clients, such as income or ESG (Environmental, Social, Governance) investing. But we are generally buying a more focused group of these stocks with fewer than 60 companies making up over three-quarters of the stocks owned in all accounts where we have full authority to make investment decisions. Individual stocks are selected based on factors including sustainable competitive advantages, superior financial strength, high quality management and potential for future growth.
Because bonds typically represent the low-risk segment of a portfolio, we want to minimize the potential for permanent loss of capital. Thus, our bond investments consist primarily of U.S. Treasury, U.S. Government Agency, and municipal bonds. When we buy a corporate bond, a credit rating of at least “A” is required.
We avoid what we don’t know
This presently includes investments in commodities, collectibles, currency, (including cryptocurrency), derivatives, private equity, and hedge funds. It also includes some stocks of smaller or foreign companies or stocks that trade more on speculation than fundamentals.
Trust Company of Vermont was chartered on September 16, 1999, a year after LTCM faltered. We can’t avoid the volatility that goes along with investing in marketable securities of high-quality companies, or even the volatility that exists in U.S. Treasuries and municipal bonds. We can, however, focus our portfolios on what we know and understand, while avoiding what we don’t! We believe this is the best way to manage capital through the next August of 1998, whenever that may be.