Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters.

Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.

Hedging, Opportunity Cost, Correlation

Mid-fiscal year through 4/30/98, Klarman substantially increased exposure to disaster insurance (mainly out of the money U.S. equity put options + hedges against rising interest rates and currency fluctuations) because of his fear of a severe market correction and economic weakness. To maintain these hedges, Klarman stated he was willing to give up a portion of portfolio upside in return for protection against downside exposure. For fiscal year ended 10/31/98, these hedges accounted for a -2.8% performance drag.

The performance drag and mistake occurred as a result of expensive & imperfect hedges:

• cheapest areas of the market (small-cap) became cheaper (Baupost’s portfolio long positions were mainly small cap)
• most expensive areas of the market (large-cap) went to the moon (Baupost’s portfolio hedges were mostly large cap)

In assessing the performance results, Klarman stated that he did not believe he was wrong to hedge market exposures, his mistake was to use imperfect hedges, which resulted in him losing money on both his long positions and his hedges at the same time. Going forward, he would be searching for more closely correlated hedges.

In many instances, hedging is a return detractor. The trick is determining how much return you are willing to forego (premium spent and opportunity cost of that capital) in order to maintain the hedge, and how well that hedge will actually protect (or provide uncorrelated performance) when you expect it to work.

The only thing worse than foregoing return via premium spent and opportunity cost, is finding out in times of need that your hedges don’t work due to incorrect anticipation of correlation between your hedges and the exposure you are trying to hedge. That’s exactly what happened to Baupost in 1998.

Catalyst, Volatility, Expected Return, Duration

Attempting to reduce Baupost’s dependence on the equity market for future results, and the impact of equity market movement on Baupost’s results, Klarman discusses the increase of catalyst/event-driven positions (liquidations, reorganizations) within the portfolio, which are usually less dependent on the vicissitudes of the stock market for return realization.

Catalysts are a way to control volatility and better predict the expected return of portfolio holdings. Catalysts also create duration for the equity investor, such that once the catalyst occurs and returns are achieved, investors generally must find another place to redeploy the capital (or sit in cash).

Klarman called cash balances in rising markets “cement overshoes.” At mid-year 4/30/98, Baupost held ~17% of the portfolio in cash because Klarman remained confident that cash becomes more valuable as fewer and fewer investors choose to hold cash. By mid-December 1998, Baupost’s cash balance swelled to ~35% of NAV.

Risk, Opportunity Cost, Clients, Benchmark

In the face a strong bull market, Klarman cites the phenomenon of formerly risk-averse fund managers adopting the Massachusetts State Lottery slogan (“You gotta play to win”) for their investment guidelines because the biggest risk is now client firing the manager, instead of potential loss of capital.

Klarman observes the psychological reason behind this behavior: “Very few professional investors are willing to give up the joy ride of a roaring U.S. bull market to stand virtually alone against the crowd…the comfort of consensus serving as the ultimate life preserver for anyone inclined to worry about the downside. As small comfort as it may be, the fact that almost everyone will get clobbered in a market reversal makes remaining fully invested an easy relative performance decision.”

The moral of the story here: it’s not easy to stand alone against waves of public sentiment. For more on this, see Bob Rodriguez experience on the consequences of contrarian actions & behavior.

When the world is soaring, to hold large amounts of cash and spending performance units on hedges could lead to serious client-rebellion and business risk. I do not mean to imply that it’s wrong to hold cash or hedge the portfolio, merely that fund managers should be aware of possible consequences, and makes decisions accordingly.

Expected Return, Intrinsic Value

Klarman discusses how given today’s high equity market levels, future long-term returns will likely be disappointing because future returns have been accelerated into the present and recent past.

Future returns are a function of asset price vs. intrinsic value. The higher prices rise (even if you already own the asset), the lower future returns will be (assuming price is rising faster than asset intrinsic value growth). For a far more eloquent explanation, see Howard Mark’s discussion of this concept.