I was at Rob Arnott's Advisory Panel meeting last week, coincidentally here in La Jolla. I had the great pleasure of listening to Professor Harry Markowitz (who developed Modern Portfolio Theory and got the Nobel Prize for it) comment at length on the presentations. He told one story that I have to share with you, as it illustrates quite well the problems faced by professional worriers.

It seems his son is an attorney (of whom Harry was clearly quite proud) and was defending an interesting client. The case involved the client, who had lost $100 million for a group of Indian tribes, and they were upset. However, they weren't quite the innocents. It seems they were not satisfied with typical returns and wanted to make a little more. They specifically instructed the money manager to invest in loans which paid 22%. Basically, these were loans to resorts and vacation spots. The manager, in an effort to protect the principle, diversified the loan portfolio by making lots of loans, thus trying to insulate the portfolio from the problem of any one or two loans going bad. 22% a year can make up a lot of losses if you can keep the losses small.

What happens, however, if a majority of the loans go bad all at once? That would clearly be a bad thing, but how could that happen? Past performance of the loans suggested that the concept was sound. However, a bad thing did happen as vacation travel plummeted after 9/11 and the follow-on recessions. Evidently, projects were cancelled or halted and the tribes who thought they were diversified against risk found they were not. Whether it was property in the US, the Caribbean, or wherever, they all were hurt in the aftermath.

Interestingly, there were five different expert witnesses (both for the defense and the tribes) that testified on diversification and modern portfolio theory. Evidently all were aware of the irony of being questioned by the son of the developer of the theory.

Long Term Capital Management is another case in point. The Nobel laureates associated with that firm had run extensive risk analysis on all the historical data. These were not wild gunslingers. They were clearly convinced that they had covered the risks.

And they had covered all the risks that were in the historical databases. However, there was one piece of data that was not in the historical numbers, and that was the effect of Long Term Capital itself. LTCM became the market and the connection between markets that had never shown any correlation. As they had to sell seemingly unconnected investments to meet margin calls, the pressure on all of the markets ratcheted up simultaneously. And the more they

had to sell, the worse it got.

The same thing with Amaranth last fall. They had PhDs running around doing analysis on risk, based on historical data, but someone forgot to factor in what it means when you become such a large part of a relatively small natural gas market that you can no longer meaningfully hedge or exit a losing position. They were averaging down into a losing trade, which is nearly always a mistake, but their market activities were of such size they distorted the market signals. Before they realized, they were getting margin calls, and the size of their own trades to raise cash was making the market move against them.

Interestingly, the trader (Brian Hunter) and his team that lost $6 billion at Amaranth are now raising money for a new fund. According to people who have read their material, there is a great deal of emphasis on risk control. Imagine that. How special. Even more amazing is that he has reportedly gotten commitments for several hundred million dollars. As an aside, you will not see that fund on any platform offered by myself or my partners. Sometimes the best risk control is to avoid it altogether.

A few years ago, I took the due diligence questionnaires for hedge funds from a number of firms (I think it was approaching ten) that analyze hedge funds, and then worked through them to compare the various documents. They all had different sets of questions. After a while I think I spotted a pattern. You could see that the differences were basically in things that had probably caused problems for the firm. They added a series of questions that were designed to make sure they never had those problems again.

I can tell you that my analysis has more depth to it than five or ten years ago, or even a few years ago. Every time there is a problem, and you hope it is the other guy and not you having it, a new set of questions appears to try and deal with that risk in the future. And you can make book on the fact that in five years the questionnaires for fund managers will have even more questions. It is always the questions that you don't ask, the data that you didn't know about, that is the problem.

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