The year that was 2015 was odd for several reasons, Baupost’s legendary value hedge fund manager Seth Klarman noted in a recent letter to investors reviewed by ValueWalk. For one, the hedge fund didn’t generate a profit, a historical oddity regardless of the market environment. But 2015 was clouded by an unusual haze, as if a dependent drug fed intravenously was about to be withdrawn from the system.
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The hedge fund with among the highest win percentages takes a strike
The Baupost Group, the Boston-based $27 billion hedge fund that finds value not only in public stocks but also private deals that sometimes require financial heft, was down -6.7% in the publicly traded portfolio 2015, while up 2.4% in the hedge fund's private investment portfolio. This was only the third losing year in the hedge fund’s 33-year history, placing them near the statistical pinnacle of all hedge funds with a 90% yearly win percentage.
Klarman notes that the fund was burnt by catching “falling knives,” some of which did not recover as anticipated. Often times during a market sell-off hedge fund managers step in to selectively find value. Baupost was said to have engaged in this practice, as we previously identified in ValueWalk. Buying on a drawdown has its rewards and punishment, yielding tremendous highs but also depressing lows.
“Upon deeper inspection, one superficially tempting investment after another turned out to be worse than they initially appeared,” Klarman wrote, subtly noting the issue of a falling market sometimes placing pressure on researchers. "In investing, however, there is no umpire calling balls and strikes, and in retrospect we could have been even more patient at the plate.”
Such are the thrills and chills of investing and market environments for each strategy come and go. Klarman gets it. 2015 wasn’t his year. Even Babe Ruth, who pointed to the exact location of a future home run, strikes out. However, the more apt comparison for Baupost might be a control pitcher like Greg Maddux who had both physical abilities and a strategic mind that kept his win percentage high.
Klarman engages in market environmental analysis without using that phrase
“Momentum investing, a strategy that is based on following trends without regard to fundamental value, worked brilliantly in 2015,” Klarman wrote. While “brilliantly” might not be the best descriptor for momentum-based trend following strategies in 2015, with most indicies near or slightly below the flat line, some managed futures funds did do well, primarily those that employ a multi-market environment strategy or their trade time-frame was conducive to capturing shorter term trends. Klarman then nonetheless simplifies the strategy: “Buy what’s been performing well and watch it go even higher.” Such funds go long and short and, importantly, there is an often sophisticated risk management component involved. The best momentum funds are, like Klarman, risk managers who work to keep a lid on downside deviation.
“By contrast, bottom-up bargain hunting – which requires fastidious research, endless patience, pattern-recognition skills derived from hard-won experience, and the application of sound judgment – didn’t prove profitable for us last year.”
When considering a rare loss for Klarman’s value strategy to the most recent market environment, recognize that, over the long term, so long as a relatively normalized economic foundation is in place, some strategies, like momentum and Klarman’s value strategy, have been proven time and time again and that a small hiccup in performance can be just that – a temporary hiccup. In Klarman’s strategy so long as the benchmark of intrinsic value doesn’t change, identifying value and waiting for the world to recognize that value can work. Just like market price trends are documentable and repeatable, accurately identifying value has worked over history.
The larger challenge to a value strategy is the market environment, and when markets are manipulated by anyone – including the undisputed lords of finance, the central bank central planners – markets can come back and bite investors, moving lower the value benchmark, which is where “catching knives” using past value benchmarks can hurt.
Klarman notes the moral hazard of quantitative fairy dust
In his letter, Klarman, like many fund managers who look at market internals and recognize the odd correlations and fragile underpinnings, isn’t happy when he sees overt manipulation regardless of the source. This manipulation has led to a moral hazard of sorts:
We have long believed that the choice to manipulate interest rates to near zero would not be without its consequences; indeed, these are now becoming more apparent. Under quantitative easing (QE), the Fed has purchased an unprecedented 61% of all Treasurys issued while nearly quintupling the size of its balance sheet, raising a legitimate question about the artificiality of today’s bond prices. Compounding the problem, near-zero rates have driven a worldwide hunt for yield, and many have found it, or thought they had, in junk bonds, the MLP space, and alternative investments.
This is the problem in today’s market environment, Klarman notes, one that is “leading to lower lending standards, eroding credit quality, diminishing returns, and excessive risk taking.” Such issues, if they remain un-addressed, will come back to bit the markets in the future.
Klarman the risk manager is noting excessive risk taking in the market as a result of quantitative easing.
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