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The Hard Truth About Hedge Funds

If you want to learn from one of the most brilliant, and secretive, investors ever, take a moment to read Seth Klarman's 2021 client letter. (You can find it with a quick Google search.)

Seth is one of those rare exceptions of someone who has been able to sustainably beat the market over a very long period of time. He's a true value investor, in the vein of Warren Buffett, using rigorous fundamental analysis to exploit the few pockets of inefficiencies that exist in the markets. Since starting his firm Baupost Group in 1982 with $27 million in capital, he's achieved annual returns of 20%, demolishing the returns provided by the broader market. He now manages $27 billion. 

Active investing rarely makes sense, and markets are, for the most part, darn near efficient. But Seth is one of the exceptions that proves the rule. He's also a perfect example of one of the great barriers to successfully investing in hedge funds and private equity funds, which is this hard truth:

If someone can truly beat the market, they probably don't want your money.

Or said differently, the more an active investor wants your money, the less likely they are skilled enough to beat the market, and vice versa. 

In Seth's case, he doesn't want your money. He closed his doors to new investors years ago. The same applies to many other esteemed fund managers, such as Jim Simmons of Renaissance Technologies. The best hedge fund and private equity fund managers have so much demand to invest in their funds that they closed their doors to new investors long before the broader public learned their names. They don't have marketing departments, won't pick up the phone if you call, and certainly don't sell their funds through financial advisors.

Still, many of the lessons that Seth conveys in this letter are applicable to all investors, including individual investors using a low-cost diversified passive approach. 

Take the following two excerpts as examples:

On taking a patient, long-term approach: “We are decidedly not trying to buy the hottest high-flyers hoping they will continue to soar. Rather, we are always anchored to valuation and focused on business fundamentals, attempting to make investments that will earn good returns across a wide spectrum of future market and economic scenarios. We strive to safely grow client capital over the next three to five years, not next week or next quarter.”

On staying calm amidst market volatility: “It is especially important for investors to maintain their bearings in periods when others do not. To do so in even the most challenging moments, investors must have been prepared for adversity all along. By the time you realize you were overexposed to risk, the market price of what you own may have already plummeted, and by then it’s too late to affordably arrange hedges or find mitigants.”

So take a moment to read Seth's annual letter. Learn from him, but don't fool yourself into thinking that you'll be able to replicate his process into market-beating returns. 

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