LTCM and the Lessons of Failure

Two-time hedge fund loser John Meriwether has launched two new hedge funds, hoping that the third time turns out better.

A founder of the legendary and infamous Long-Term Capital Management, which collapsed in 1998, requiring a government bailout, Meriwether has unveiled his JM Advisors Management’s global macro strategy. The new fund is available in both onshore and offshore versions, according to regulatory filings.

Going with global macro is something of a change for Meriwether, and for JMAM. The Greenwich, Conn.-based firm was originally slated to run the same relative-value arbitrage strategy used at LTCM and JWM Partners, which Meriwether closed last year after taking a beating during the financial crisis.

JWM Partners lost some 44% over its last two years. Meriwether founded it in 1999, just a year after the spectacular demise of LTCM.

Hmm. So who are the investors lining up to give this guy another chunk of change?

The above chart shows the carnage that engulfed LTCM investors in 1998 (though it doesn’t show the substantial costs of the bailout, or the carnage inflicted on the rest of the Street).

For a few good years, LTCM snatched up nickels in front of bulldozers with huge leverage, while the fund’s Nobel laureates got high on their own supply with seriously addle-brained concepts like “Continuous-Time Finance.” Then it all went wrong, in accordance with the “100 year storms” that actually seem to occur every five or six years.

LTCM, and later vehicles of its ilk such as the Bear Stearns High-Grade Structured Credit funds — which had positive returns 40 months in a row before going Kaboom — became living proof of Michael Milken’s admonition that “leverage is not a business model.”

But Meriwether didn’t get the memo, and blew up with the same approach a second time.

To be clear, past failure is not always cause to dismiss future success. As most entrepreneurs and traders know, failure can have an upside — IF the result is knowledge, humility and, above all, wisdom gained from one’s mistakes.

Some legendary traders swear by the value of their early failure experiences. Paul Tudor Jones has discussed the value of “losing his stake” a few times in his early 20s, which seared the importance of risk management deeply in his brain (and equipped him for more than a quarter century of success to follow).

PTJ also says he is wary of traders who haven’t peered into the abyss at least once — preferably early on in their careers! — because that trial by fire is so critical in transfusing a respect for risk into one’s DNA.

The trouble with guys like Meriwether, though, is the open question as to whether they have learned from their failures at all.

For examples of how not to react after a catastrophic loss, look no further than LTCM and the more recent case of Bill Miller and the Legg Mason Value Trust.

When LTCM, and much later Miller, blew up, there was no real recognition of failure — and no real willingness to genuinely own up to (let alone learn from) the serious mistakes that were made.

Instead, the weak apologies offered were actually thinly veiled attempts to place the blame on others — and subconsciously deny the existence of failure in the first place!

There is a glaring lesson here: When a trader (or investor) loses a disastrous sum of money and their personal reality-distortion field keeps them from processing the real reasons why, the best thing to do is stay the heck away!

Who knows, maybe Meriwether is a changed guy. Maybe his third go, and his new global macro focus, will be infused with a deep-seated respect for risk that keeps hm out of the soup.

But somehow that seems hard to believe — especially since macro arguably requires MORE humility, MORE flexibility and MORE deeply embedded risk-control protocols than most any of the other trading disciplines.

In fact, the fluidity and flexibility of the macro mindset, in which one is constantly dealing with imperfect and incomplete information sets, is the 100% polar opposite of the “We’re never wrong, when a position goes against us we just buy more” attitude that data-emboldened value investors and number-crunching relative value traders tend to embrace.

The arrogance of academia and the rigidity of self-imposed theories are death traps when it comes to trading macro. In some corners of the market, arrogance isn’t necessarily fatal. But if you show arrogance in the middle of the ocean or high up on a mountainside, you die.

Failure, if genuinely embraced and absorbed, can be a stepping stone to greater wisdom and lasting success. Deny it or suppress it, however, and that same pattern of failure becomes a millstone around the trader’s neck, dooming them to replicate the same arrogance-prone errors for the whole of their careers. It will be interesting to see how Meriwether fares this time.

JS

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