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Robert Huebscher
Robert Huebscher
Articles (5983)  | Author's Website |

Seth Klarman: Why Most Investment Managers Have It Backwards

June 16, 2009

For value investors, last fall’s crisis provided an unprecedented opportunity. Down markets are a great time to buy securities, as Graham and Dodd said in Securities Analysis, since the average investor can usually only get them “at prices that the future may cause him to regret.”

For Seth Klarman, founder and president of the Boston-based Baupost Group, last fall was a period that offered many of those opportunities. He delivered the keynote lecture at the annual meeting of the Boston Security Analysts Society last week. Klarman also was the lead editor of and authored the preface to the sixth edition of Graham and Dodd’s Securities Analysis, published in 2008.

In that speech, Klarman praised his team for remaining clear-headed amid exceptional market volatility and positioning the firm’s portfolio to deliver superior long-term performance for its investors.

Unfortunately, Klarman said, clear, long-term goals are not the norm throughout the industry. Before detailing the most attractive opportunities created by the crisis, Klarman first addressed a fundamental conflict within the investment management industry that he said is at odds with investor objectives. 

Investment managers, such as pensions and endowments, exist in perpetuity and should be focused on long-term wealth creation. Yet performance is almost universally evaluated using short-term results – managers are compared using quarterly, monthly, or even daily returns, creating extreme short-term pressures. “Managers who do well in the short term are rewarded with more assets,” he said. “Those who do not do well in the short term often don’t survive to see the long term.”

“Managers who do well in the short term are rewarded with more assets,” he said. “Those who do not do well in the short term often don’t survive to see the long term.”

“Money managers know the Sword of Damocles is poised to fall on them next,” he added, which forces them to sacrifice long-term wealth creation to pursue short-term gains.

Klarman strives to avoid such counterproductive incentives, mostly by investing for clients – like endowments – with a long-term focus, and avoiding others – like funds-of-fund and unsophisticated investors – whose goals may be at odds with his own.

If the technology existed to permit real-time performance measurement of his portfolios, Klarman said, he wouldn’t want it, since it would run completely contrary to his long-term focus.

After all, the result is behavior that makes little sense. Investment managers can usually be found “scurrying around” to achieve superior daily or weekly performance, even though their proper goal is to realize substantial gains farther down the road.

By contrast, managers with a long-term focus gained extraordinary advantages in the current crisis. Klarman described a situation that illustrated the disparity between managers who are able to focus on long-term objectives and those who must engage in short-term performance races: His firm had the opportunity to bid on a publicly traded debt instrument. Another bidder was willing to pay significantly more than his initial bid, but Klarman still determined that he would earn a 25% return, even at the higher price.

Klarman said every client should want their manager to make such an investment. But most with a nearsighted focus would be extremely reluctant to pull the trigger, particularly because the bonds in question lack liquidity and are unlikely to be marked up to the level where this trade would take place.

Having a long-term focus requires keeping the emotions of fear and greed in check. For most of the last 12 months, fear dominated greed, causing investors to flee to cash, despite its negative yields. Those investors, along with many who suffered losses on Treasury bonds bought at depressed yields, also paid dearly in opportunity cost – their inability to buy securities at depressed valuation. “Managers who were too fully exposed were unable to appreciate the opportunities,” Klarman said.

Frightened clients made things worse for managers, who are unfortunately guided by what clients think – or what they are afraid clients are thinking.

All managers made some mistakes and likely posted losses. Shrewd investors, who picked up bargains, looked like “risk takers.” Klarman even admitted to some mistakes of his own – he stretched his criteria to buy some marginally cheap stocks, for instance, and one of his private investments went bad.

But Klarman does see a sliver lining: He believes the current crisis may embolden more managers to stand apart from the crowd – and perhaps even charge fairer fees.

Among those who will have the opportunity to stand out are managers with broader mandates, who are particularly well positioned to serve clients’ needs, Klarman said. Narrowly focused managers, such as junk bond managers, he said, are often forced to be 100% invested, regardless of the risk/return profile of their investable universe. Such constraints eliminate the potential for contrarian thinking, which is critical to the success of value investors like Klarman.

Continue to read about Seth Klarman’s view on the current rally

Robert Huebscher


About the author:

Robert Huebscher

Mr. Huebscher is the founder and CEO of Advisor Perspectives, a web site and newsletter that provides investment strategy analysis for financial advisors and wealth managers. In 1982, he founded the investment software division of Thomson Financial, where he created the PORTIA product, a portfolio management system for institutional investors. In 1990, he founded Hub Data, a market data redistribution service, which he sold to Advent Software in 1998. He has also worked in the account aggregation field, as a consultant to both vendors and wealth managers. He is a graduate of the Harvard Business School (1982) and Connecticut College (1976).

Visit Robert Huebscher's Website

Rating: 3.9/5 (16 votes)


Davknutz - 10 years ago    Report SPAM
making investments is always a tricky decision, make sure you know all the ins and outs before you hand over any money to an investment manager.

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