When Academics Go Bananas

You may have noticed already, but I constantly refer to academics and academia. As a firm, we put a lot of value on the ideas that come from the ivory towers and have academic support for nearly every strategy and sub-strategy that we employ.

We appreciate the thoughtfulness, research, peer-review process that has contributed so much to the way we think about markets.

But, sometimes, academics can get a little batty.

As loyal readers know, I went to Austin Texas last week to the ‘Advanced’ conference put on by a firm that we work with, Dimensional Fund Advisors (DFA). It was a very interesting conference and the group heard from a distinguished group of academics, including two Nobel Laureates, Gene Fama of the University of Chicago and Myron Sholes, from Stanford.

I’ve written about Fama before, since he is really the godfather of modern finance, but Scholes occupies a very high place in the pantheons as one of the co-creators of the famous Black-Scholes option-pricing model.

The Black-Scholes model was an incredibly important development in 1973 that describes the price of an option over time and has come to serve as the foundation for derivatives pricing, and is commonly used to measure and transfer risk.

To make a long story short: Myron Scholes knows more about investing than just about anyone, especially me. But that doesn’t mean I would invest with him.

After a few decades in academia, Scholes understandably decided to put some of his knowledge to good use and went to work at Salomon Brothers on Wall Street as the co-head of the bond department during the 1990s along with John Meriwether, who was immortalized in the Michael Lewis bestseller, Liar’s Poker.

In 1994, Meriwether, Scholes and a band of brilliant traders left Salomon to form Long-Term Capital Management (LTCM), a hedge fund that made sophisticated bets with a tremendous amount of leverage.

At the beginning of 1998, for example, the firm had approximately $4.5 billion in capital and borrowed $124.5 billion to bet on the bond market: a leverage ratio of 27:1.

With that much leverage, it only takes a 3.5 percent move on your position to wipe out all of your capital and that’s exactly what happened when Russia defaulted on its debt in 1998. LTCM was wiped out and was rescued by other firms at the behest of the Federal Reserve.

Of course, Scholes was just one member of the management team and does not deserve all of the blame for LTCM’s decline – most of that credit goes to Meriwether, the firm’s leader.

But, some years later, Scholes went on to co-found Platinum Grove Asset Management, a hedge fund that reportedly had terrible performance of around -50 percent in 2008 due to leveraged positions in relatively illiquid markets.

To be fair, a lot of people lost a lot of money in 2008 and since I don’t have access to Platinum Grove’s actual performance record, it’s hard to draw meaningful conclusions.

The point, though, is to simply say that being a brilliant academic isn’t enough. We absolutely rely on academic work, but there is an important real world component to what we do that just requires some common sense.

We’ll continue to keep up with what comes out of academia, but we’ll also take it with a grain of salt from the real world.