PIMCO, Beating the Market, and Long-Term Capital Management

Photo courtesy Flickr user boxchain, Creative Commons

Noah Smith read Reuters’ article on the decline of PIMCO and wrote a great post about the challenges that successful funds face as they grow.  In short, the additional capital that flows into a fund that has been beating the market makes it more difficult for the fund to continue to beat the market.  Smith concludes:

Note that this is not Efficient Markets theory. This is just arithmetic. But the more “efficient” markets are, the quicker it will become impossible to beat the average as you grow in size, because the available mispricings that you can exploit to get excess returns will be more limited.

So here’s the lesson: if investors “expect” an asset management company to beat a comparable index fund by the same number of percentage points year in and year out, they will be disappointed, because the company will soon get so big that it is almost indistinguishable from an index fund (except that it will have higher fees). Such fixed expectations of excess returns are not rational. But if investors do have such expectations, asset managers will have an incentive to accept greater and greater risk in order to have a chance of holding onto their clients. This is exactly what that article says is happening with PIMCO.

Smith is talking about PIMCO here, but there’s another fund that even better illustrates this idea: Long-Term Capital Management.  LTCM started off in the early 90’s and initially made a killing in fixed income arbitrage, using innovative statistical models that no one else had.  As they became more and more successful, though, things started to go south.  As Roger Lowenstein explained in his book on LTCM, When Genius Failed:

Whether Long-Term wanted to admit it or not, the secret of bond arbitrage was out. By the late 1990s, almost every investment bank on Wall Street had, to some degree, gotten into the game. Most had separate arbitrage desks, with traders specifically assigned to look for opportunities in every nook and cranny of the business. Lured by the scent of the fantastic profits being earned in Greenwich; other banks were reaching for the same nickels as Long-Term. Inevitably, they whittled away the very spreads that had attracted them; thus do free markets punish success. Long-Term had always been dogged by imitators, but now the imitators were piling on faster than ever. No sooner did a spread open up than rival traders plugged it. “Everyone else was catching up to us,” Rosenfeld complained, “We’d go to put on a trade, but when we started to nibble, the opportunity would vanish.”

Characteristically, Meriwether encouraged the firm to explore new territory. Even at Salomon, the troops had always sought to extend their turf. Hadn’t they moved from swap spreads to mortgage-backed securities? Hadn’t they branched into junk bonds and European debt? In retrospect, such moves had been baby steps, not bold new departures. But the partners’ experience-to them, at least-seemed to belie the adage that it is dangerous to try to transport success to unfamiliar ground. Trusting their models, they simply rebooted their computers in virgin terrain.

LTCM ultimately failed for a number of reasons, but chief among them is the phenomenon explained above: their success in bond arbitrage spawned imitators, who made it more difficult to be successful in bond arbitrage.  While you might be able to invest $1 billion in profitable trades, investing $2 billion or $3 billion with the same rate of return that you achieved on your first billion is going to be very difficult, especially when everyone around is now trying to do the same thing.

LTCM responded to these pressures by applying their models to unfamiliar asset classes, jacking up their leverage, and trying their hand at investment strategies outside of their expertise, like merger arbitrage.  Risk management flew out the window, as LTCM began making large directional bets, rather than the arbitrage trades that were theoretically market-neutral, with dangerously high leverage.  The end result was that LTCM made the same investments it had in the past but in an even riskier manner and also made a whole series of new, riskier investments, all in an effort to maintain their high returns.  Rather than continuing to beat the market by a huge margin, as it had in its earlier years, LTCM imploded in spectacular fashion.

Of course, LTCM is an extreme example of this phenomenon.  The problems at PIMCO don’t seem to be anywhere near the same magnitude as at LTCM.  It sounds like some of the things that happened at LTCM are happening at PIMCO–new asset classes, new types of financial instruments, Gross doubling down on a bet as it turned against him.  But even last year when it was in the bottom 10% of its peer group, PIMCO’s Total Return Fund still returned 4.39%.  That’s pretty bad considering its peers’ average return of 6.39%, and even worse considering PIMCO’s sterling record, but it doesn’t suggest that PIMCO’s investment strategy, from Gross’s bearish bet on Treasuries to its reliance on derivatives, poses the level of risk seen in LTCM’s case.  Rather, the danger for PIMCO seems to be that it will start to achieve average returns on a regular basis, which is precisely what should happen in the long-run.

This is in part due to its increased size, as discussed by Smith and above.  But this is also true because it’s hard to get lucky again and again.  Even if you allow that the probability that a manager outperforms the market is 50% dependent on that manager’s skills—which I consider to be a generous estimate—that other 50% is still largely chance.  In order to consistently beat the market, a manager both has to be right about the market and lucky year after year.  Just as it’s unlikely that you’ll get 10 heads ten times in a row when flipping a coin, very few managers are going to be lucky over an extended period of time.  As for the manager’s alpha, even talented managers like Bill Gross are wrong in a big way every now and then, as his bearish Treasury bet shows.  In the end, most managers are going to achieve market returns—and that’s before you deduct fees.  And this is why you should invest in low-cost index funds.

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