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Chapter 12. The Eggheads Crack > Imitation May Be Flattering, But…

Imitation May Be Flattering, But…

Investors in LTCM earned over 40% per year in 1995 and 1996. However, other hedge funds and institutional investors started to figure out what LTCM was doing and began to copy its strategy. This competition eroded much of the profit potential of the trades. When LTCM's computer models discovered a mispricing, they found that other investors were making the same trades. The result was that LTCM was not finding great investment opportunities anymore. LTCM earned a 13% return in the first half of 1997. Indeed, LTCM investors received 27% for the year. Although this is quite a good return, it was much lower than the previous two years' return, and the S&P 500 Index earned over 30% that year.

The consequence for LTCM was that it started looking for mispricing in other markets. In its search, it applied the same approach as before. It looked for different, but similar, securities that seemed over- or underpriced, considering their risk. LTCM placed hedge positions in the stock market, in European bonds, in asset-backed securities, and in emerging market bonds. This may have looked like it increased LTCM's diversification by investing in many asset classes. However, it almost always placed the same kind of hedge. Its hedge bet was one in which it would profit when the price of a risky security would increase relative to a less risky security. In other words, the prices of two securities would get closer together. The two securities might be the stock of two companies that announced a merger. Or, the securities might be Russian bonds and German bonds.


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