Seth Klarman has been critical of index funds in the past. He’s been equally critical of active funds. It turns out, the behavior of fund managers and investors can work against each other. Career risk, short-termism, optimism, return chasing, and herd mentality can lead managers, investors, and markets astray.
I recently read three articles in which Klarman covered this. Below are some of his thoughts.
On looking for answers after a crash:
People seeking answers to why the market plunged usually emphasize the immediate events that precipitated a selling panic, when in fact these events are but minor symptoms of much more severe underlying problems.
On the cause of market overvaluation:
Indeed, today’s financial markets have a distinctly upward bias. Anyone can buy a stock, but only shareholders and short sellers can sell. Short sellers are actually a major force in limiting market overvaluation, even with numerous rules that constrain them. Wall Street, on the other hand, tends to encourage market overvaluation through excessive optimism: analysts have been known to write 50 buy recommendations for every sell, for example. Today, Wall Street is optimistic not only from habit or because optimism is good for business; with billions of dollars of firms’ capital tied up in merchant banking transactions and bridge loans, Wall Street is optimistic out of necessity.
On the tendency to turn to EBITDA as a valuation tool:
This analytical tool supposes that equipment does not wear out and buildings don’t need to be maintained, even though nobody thinks this is really the case. Wall Street simply has chosen to ignore the financial reality, because it has become immensely profitable in the short run to do so.
On mistaking skill, luck, and cycles in the recent returns of fund managers:
When you get right down to it, it is simple to compare managers by their investment returns…It is far more difficult – impossible except in retrospect – to evaluate the risks that managers incurred to achieve their results.
Investment returns for a brief period are, of course, affected by luck. The laws of probability tell us that almost anyone can achieve phenomenal success over any given measurement period. It is the task of those evaluating a money manager to ascertain how much of past success is due to luck and how much to skill.
Many investors mistakenly choose their money managers the same way they pick horses at the race track. They see who has performed well lately and bet on them. It is helpful to recognize that there are cycles of investment fashion, different investment approaches go into and out of favor, coincident with recent fluctuations in the results obtained by practitioners. If a manager with a good long term record has a poor recent one, he or she may be specializing in an area that is temporarily out of favor. If so, the returns achieved could regress to their long-term mean as the cycle turns over time; several poor years could certainly be followed by several strong ones.
On the short-term nature of career risk in active funds:
Those investors, quite like today’s big mutual-fund complexes, were disproportionately worried about about their short-term investment results and their clients’ perception of same. In such a world, relative underperformance is a disaster and the longer term is measured by the frequency with which investment results are evaluated. Risk for them is not being stupid but looking stupid. Risk is not overpaying, but failing to overpay for something everyone else holds. Risk is more about standing apart from the crowd than about getting clobbered, as long as you have a lot of company.
It is so much easier for them to sell whatever has recently disappointed investor expectations, no matter how inexpensive it has become. Mutual-fund managers, desperate to put cash to work, don’t buy what is cheap but what is working, since what is cheap by definition hasn’t been working.
On knowing why you bought an investment:
An investor who initially purchases based on value knows to buy more when an already undervalued stock falls and to sell when it becomes fully valued. An investor in an internet stock or in the extraordinarily expensive shares of a very good company has no idea what to do when the price moves up or down. This creates a serious dilemma for the great majority of investors and a real opportunity for a few.
On the arrogance of value investing:
At the root of value investing is the belief, first espoused by Benjamin Graham, that the market is a voting and not a weighing machine. Thus an investor must have more confidence in his or her own opinion than in the combined weight of all other opinions. This borders on arrogance, the necessary arrogance that is required to make investment decisions. This arrogance must be tempered with extreme caution, giving due respect to the opinions of others, many of whom are very intelligent and hard working. Their sale of shares to you at a seeming bargain price may be result of ignorance, emotion or various institutional constraints, or it may be that the apparent bargain is in fact flawed, that it is actually fairly priced or even overvalued and that the sellers know more than you do. This is a serious risk, but one that can be mitigated first by extensive fundamental analysis and second by knowing not only that something is bargain-priced but, as best you can, also why it is so. (You never know for certain why sellers are getting out but you may be able to reasonably surmise a rationale.) This is the position in which investors should, over and over, want to put themselves (and an astonishingly different type of consideration than the great majority of today’s investors are bothering to make).
On being a contrarian in a bubble:
Ignored, out-of-print titles about the madness of crowds (not to mention the importance of a margin of safety) suggest that the majority cannot be right in the long run. Being very early and being wrong look exactly the same 99% of the time…
Who’s to Blame When the Market Drops? Analysis Often Misses Mark – ’89
Do They Eat at Home – ’91
Why Value Investors are Different – ’99