For anyone who has read the book Fooled by Randomness by Nassim Nicholas Taleb, the name Victor Niederhoffer may sound familiar (if you haven't read the book, check out this article by Malcolm Gladwell). "The Blow-Up Artist", a great article in The New Yorker, discusses Niederhoffer's most recent financial troubles. Although Niederhoffer and Nassim Taleb are friends, after the events of the last two months I believe that Taleb has the last laugh.
Victor Niederhoffer is a well-known hedge fund manager who got his start managing a trading firm in the 1980s. From 1982-1990, he partnered with George Soros and ran the Fixed Income and Forex divisions of Soros' firm. Niederhoffer has published two books: The Education of a Speculator (1996) and Practical Speculation (2003). Since 2001 he has run Manchester Trading LLC, which manages three small funds with total assets under management of about $350 million at the end of June. Manchester's main fund had returned 50% annualized through the end of 2006, earning it a prize for best performance by a Commodity Trading Adviser.
Despite the level of respect for him in the trading world, Niederhoffer is most well known for the blow-up of his hedge fund in 1997. After the Asian financial crisis and a 7% one-day drop in the Dow, Niederhoffer Investments lost a majority of its capital and was forced to close down. These losses wiped out virtually all of the gains the fund achieved racking up 35% annualized returns since inception.
Black Swan Déjà Vu
Through the end of June, Niederhoffer's funds were up 30-40% year-to-date. Extremely impressive, by any stretch of the imagination. By looking at the track record of Matador (his largest fund) over the last 5½ years, one might assume that over the next 5 years Matador would deliver similar returns. But that's just the problem with looking solely at track records—even if they span over 5 years. Niederhoffer's funds have high leverage in order to take advantage of the small gains received on each individual investment. Basically, he's picking up pennies in front of a steamroller—and borrowing money to turn those pennies into nickels.
But like Long Term Capital Management, those "steady" returns are bound to come to an end. They may say the funds are disaster-proof, but just because their models predict a certain six-sigma event will happen once every 10,000 years, it means very little. The nature of these Black Swans (high-impact, unpredictable events) is that they happen much more often than models predict. And with a leveraged fund that invests in derivatives, it can spell disaster. Below is a passage from Fooled by Randomness where Taleb discusses Niederhoffer's first financial meltdown in 1997:
Niederhoffer's publicized hiccup came from his selling naked options based on his testing and assuming that what he saw in the past was an exact generalization about what could happen in the future. He relied on the statement "The market has never done this before," so he sold puts that made a small income if the statement was true and lost hugely in the event of it turning out to be wrong. When he blew up, close to a couple of decades of performance were overshadowed by a single event that only lasted a few minutes.
Ten years later, it seems as though Niederhoffer hasn't learned his lesson. "It is impossible to go through what Victor went through without it altering what you do," said a colleague of Niederhoffer's to The New Yorker in July. "It made him more conscious of risk, more attuned to it. It was an expensive education, but the important thing is that it wasn’t wasted." Apparently not. Last month, Niederhoffer was forced to close his flagship Matador fund after it lost 75% of its value since the market volatility began at the end of July.
Said Niederhoffer: "I was caught wrong-footed in the market turbulence. I’m not as smart as I thought I was. ... The movements in volatility were greater than I had anticipated. We were prepared for many different contingencies, but this kind of one we were not prepared for." I believe it was Warren Buffett who said that a string of huge returns multiplied by a single zero is still zero. Victor Niederhoffer, take note.
Look forward to future posts on investing under conditions of uncertainty, allocating capital using the Kelly Formula, and the advantages of value investing in this random world (I'll call it my "Adventures in Extremistan" series).