4 Takeaways From Seth Klarman’s Letter To Investors

By: Wayne Duggan

Investors are still trying to make sense of what to expect now that Donald Trump is president. So far, the market is generally optimistic about Trump’s pledges to reduce regulations and significantly lower corporate tax rates. The SPDR S&P 500 ETF Trust (NYSE: SPY) is up 9.4 percent since Election Day, but not everyone is convinced that Trump is good news for the market or the economy.

In his annual letter to investors, Baupost Group manager Seth Klarman expressed his concern over what investors may face in the Trump Era. Klarman, who has only had three down years since 1982, currently manages more than $30 billion.

Here are four things you need to know from the Klarman letter.

1. Protectionism is not a recipe for long-term success.

“While they might be popular, the reason the U.S. long ago abandoned protectionist trade policies is because they not only don’t work, they actually leave society worse off,” Klarman wrote. He sees Trump’s moves to reduce or eliminate free trade and increase import tariffs as economic misfires. Klarman believes globalization is the natural path for economic growth, and protectionism is artificially fighting that trend.

2. Trump’s unpredictability is bad for stocks.

“Trump’s erratic pronouncements—about tariffs, corporate actions, the cost of F-35s, a nuclear weapons buildup, and whatever else—are unusual and unsettling to say the least,” Klarman wrote. According to Klarman, volatility and uncertainty are two things that typically terrify investors and drive share prices down over time. In addition, business leaders want predictability and stability when it comes to public policy so they can understand exactly what they are getting themselves into when they invest in their businesses.

3. Tax cuts and deregulation are double-edged swords.

While this policy approach could certainly stimulate economic growth, it could just as easily drive interest rates higher and increase inflation as well. “And, of course, a trade war or international crisis would be highly disruptive and costly for business and, more importantly, it would have a wrenching impact on people’s lives,” Klarman wrote. He is concerned that investors seem to be focusing on all of the potential benefits from Trump’s plan and ignoring the potential economic fallout.

4. The era of the ETF may be ending.

As a whole, hedge funds and active money managers have significantly underperformed index ETFs in recent years. Ironically, Klarman believes that underperformance may have indirectly set the table for an extended period of outperformance in the years ahead.

“The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become,” Klarman wrote. In other words, the worse active managers perform, the more investors are driven to index ETFs. The more index ETFs invest equally in the entire market, the more overpriced certain stocks become relative to others. That mispricing creates opportunity for fund managers to cherry pick stocks that should outperform index ETFs over time.

Disclosure: the author holds no position in the stocks mentioned.

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