John Meriwether...Fool Me Twice?

Includes: DIA, QQQ, SPY
by: Todd Kenyon, CFA

He's back. Back to his old tricks, just not quite as bad. And only because people were willing to give him billions to play again.

No, not Donald Trump. John Meriwether, the infamous founder of the even more infamous Long Term Capital Management, (which strangely enough made highly-levered short term bets on a variety of fixed income and other securities). Of course LTCM lives in infamy due to it's $4B implosion in 1998 which forced a coordinated bailout to avoid a financial market train wreck (ironically, Bear Stearns was the only big investment bank that declined to participate in the bailout).

With merely $5B in capital, Long Term had borrowed about $125B and had off balance sheet


positions with notional values of over a trillion dollars. LTCM employed up to 50x leverage because its trades, by design, only returned very small percentage gains, and its roster of rocket scientists and Nobel Prize winners believed that it was impossible for many of their bets to go against them at once - the diversification was too great (hmm - sounds familiar...). History has shown again and again however that so-called diversification works until it doesn't. When things get bad, everything correlates. The Russian financial crisis provided another example of stress-induced correlation, and as essentially all of LTCM's trades started going against them, Wall Street vultures piled on and that was that.

The Russian Crisis was one of Nassim Taleb's "Black Swans" - an unprecedented and unlikely event that nonetheless was possible. Mr. Taleb described LTCM's strategy as akin to "picking up pennies in front of a steam roller" - a fairly certain series of small gains with the unlikely but real possibility of a fatal event.

The WSJ featured an article entitled "A Decade Later, John Meriwether Must Scramble Again". Amazingly, only a year after the LTCM disaster, Meriwether started another firm with LTCM alumni. Once again, investors gave him billions to manage. As the WSJ reports, until this year the funds have had mediocre but positive performance. They have performed well below peers and their benchmarks, but haven't lost money. Now, it is starting to look far worse as one fund is down 28% YTD. Meriwether has told investors he learned his lesson, and hence he now only employs a "mere" 15x leverage. Mere that is, until another black swan shows up. And show up it has in the form of the credit crunch. If investors all decide to bail and his bets continue to go against him, he's finished. Again.

This all begs the question as to why investors would give this guy billions shortly after he precipitated a major financial crisis. Not only that, they pay him 2% of assets + 20% of gains (i.e., $46 million last year just for the management fee!), only to have him underperform an index fund for years and then possibly implode yet again. Here he is back in the same sort of pickle as the one that killed LTCM, albeit with less capital and leverage. Thankfully, he likely won't cause a financial crisis (other than for his investors) this time. Will two times be enough to finally teach investors a lesson? Fool me twice, shame on me, fool me three times...?