Cracks Begin to Show
Early 1998 warning signs — shrinking spreads, growing imitators, and a fund that had grown too large for its own strategy.
By early 1998, the book documents several converging warning signs that the fund's remarkable run was becoming harder to sustain: the very success of LTCM's strategy had attracted a wave of imitators across Wall Street's other proprietary trading desks and competing hedge funds, all chasing the same convergence trades, which itself compressed the small price gaps LTCM depended on, since more capital chasing the same discrepancies pushes them to converge faster and leaves less room for future profit — a self-limiting dynamic common to strategies that work precisely because not everyone is doing them yet.
LTCM's own response to this shrinking opportunity set, as the book documents it, was to push further into larger positions, additional markets beyond its original core competency (including equity volatility and emerging-market debt), and yet more leverage to maintain the fund's historical return level even as the underlying edge per trade was shrinking — a decision Lowenstein frames as the critical turning point where the fund's growth began actively working against the discipline that had made its original, narrower strategy sound.
The book identifies this specific response — compensating for a shrinking per-trade edge by increasing leverage and expanding into less-familiar markets, rather than reducing scale to match the smaller genuine opportunity — as the single decision that transformed LTCM from a fund with a real, if narrowing, edge into one whose returns depended increasingly on leverage and diversification into markets the founding team understood less deeply than their original bond-arbitrage specialty, quietly increasing the fund's true risk well beyond what its historical volatility figures, based on the earlier, narrower strategy, still implied.
- LTCM's own success attracted imitators, compressing the price gaps the fund's strategy depended on and shrinking its available edge.
- The fund's response was to expand into new markets and add leverage to maintain historical returns, rather than scale down to match the smaller genuine opportunity.
- This decision quietly increased the fund's true risk well beyond what its historical volatility figures, based on its original narrower strategy, still implied.