In his 2015 year in review, one topic Baupost’s Seth Klarman addressed is perhaps the issue that most impacts society and the financial services industry, particularly if one is to consider the history of the last 20 years. But this same topic was overlooked by much of the media reporting on his letter, including my own.
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Also see additional ValueWalk coverage on Baupost’s full-year 2015 letter to investors.
- Seth Klarman: Now’s Not The Time To Give Up On Value
Baupost: Making Use Of Market Inefficiencies To Find Bargains In Distressed Debt - Klarman “Catching Knives” Experiences Rare Yearly Loss, Looks Forward
Has a fiduciary standard been lost? And if one is an institutional investor, don’t they have a responsibility to find those who uphold this standard?
Klarman addressed the importance of being a “fiduciary.” This was at one point a sacred topic that, over the past 20 years, appears to have somehow faded in importance if not being mocked by some of the ruling establishment.
There is both a hard and a soft definition of the word “fiduciary,” and Klarman, who uses Yale University Chief Investment Officer David Swensen as an example one, nails the defining the concept:
While a fiduciary relationship is founded on trust, trust isn’t enough. An effective fiduciary must also be intelligent, wise, and humble. Intelligence is inborn, but wisdom is shaped by experience. Also essential is the self-awareness to avoid behavioral biases, and the adroitness to look around corners and recognize patterns. Fiduciaries must possess the humility to know they could be wrong, and thus to err on the side of prudence and capital preservation. Fiduciaries must have the clarity of mind to identify conflicts of interest, and the character to avoid them as much as possible.
Klarman, for his part, entered the hedge fund industry at a time when being a fiduciary meant questioning authority and looking at investments from all angles. It can be argued that today, based on numerous obviously fraudulent that omitted clear risk issues – Enron, 2008 fraud issues, MF Global bonds and even currently questionable investment offerings – that the concept of being a fiduciary, doing the hard detective work behind an investment and operating in the best interest of clients, appears to be going the way of the eight track tape. Any fiduciary that blindly trusts the ruling establishment is failing in their fiduciary responsibility.
Was the 1990’s the most defining point in the history of financial services?
Contrast Klarman’s definition of fiduciary with a minority of the modern day rulers of finance who have come and gone. Former MF Global CEO Jon Corzine, for instance, might suit as an entertaining example. He was head of Goldman Sachs at a time when the credit default swap derivative was rolling into the mainstream. There was minority resistance in Washington D.C. to this “financial innovation.” A pesky do-gooder from the little-known and often pretentiously dismissed Commodity Futures Trading Commission would fight the ruling bank establishment over the simple request to study the issue. A demure yet talented female mind mind put the country above her financial gain. Brooksley Born, then CFTC Chair, would fight a gallant battle that is important to understand from a historical perspective. She lost that fight and then afterward many of the financial crashes – 1998, Enron and the 2008 financial crisis – all prominently featured unregulated derivatives that seemed to prominently display a lack of respect towards the concept of being a fiduciary. She would then be harshly dealt with, if not disrespected, by accused bank operative and “enforcer” Larry Summers, along with a gang of those who were handsomely rewarded for clearing the way for nearly 20 years of change that hasn’t always been positive. Over this period of time what it meant to be fiduciary – and more significantly the importance of this concept – seems to have fallen by the wayside.
For his part, Klarman doesn’t connect these dots as much as he goes after the “for profit, exchange traded” alternative investment manager. Baupost, he points out, is rewarded when clients achieve success.
At Baupost, we are rewarded not only from ownership of the business but also from the returns achieved by investing our own capital alongside our clients. Our interests are, thus, closely aligned with those of clients, and we all benefit from building up the firm’s capabilities. We long ago decided to remain privately owned by employees rather than go public or sell ownership to outsiders.
A public company – any public company, including a hedge fund – is bound as a fiduciary to put its profits before all else, and that can mean ushering the client to the sidelines. It’s not easy to withstand the popular onslaught. Back in the day when Klarman learned the ropes, those who did not operate as fiduciaries were shunned from the industry if not severely dealt with by regulators, when they were allowed to equally enforce rules and laws for all participants. Now it seems those violators are rewarded.
It is easy for ethical transgressions to creep in and distort the thinking or behavior of an investment firm. The investment business is rife with conflicts, and they cannot all be avoided. The challenge for a fiduciary is to set up a client-friendly structure and adopt rules, policies, and procedures that serve to minimize conflicts, and err on the side of clients when they do arise. Fiduciaries must surround themselves with colleagues who share these same values and priorities.
There is a common issue in Wall Street’s increasingly micro focus on quarterly profits that some corporate executives note is bad long term for the country, the company’s employees and the company itself. Talk to senior executives at the multi-billion dollar private company S.C. Johnson, for instance, and they don’t focus on next quarter’s earnings, they focus on the next generation. They are loyal to their region, their country and generally contribute to society. This is what happens when the focus is taken off quarterly profits at all costs.
Going public might, for example, dramatically change incentives, creating a focus on asset gathering or becoming hyper risk-averse (to maintain assets under management) and thereby failing to fully seize opportunities. By enriching current management at the cost of the next generation of the firm’s leaders, it also mortgages the future. Going public or selling out dishonors the original deal.
Klarman: Good fiduciaries are born, not nurtured
When weighing in on how a good fiduciary is developed, Klarman walks on politically interesting territory. He says good fiduciaries are born; morality is inbred:
My belief is that a person’s character is largely determined by their wiring at birth. Not everyone will find it easy to truly put others first. But wiring is not the whole story. A good person ensnared in an unethical environment is likely to lose his or her way. And a person who hasn’t spent much time thinking about or caring for others, when placed in the right environment, may well turn
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