Howard Marks, Oaktree Capital — 2024-10-22
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Memos from Howard Marks 2024-10-22T07:00:00.0000000Z" pubdate title="Time posted: >10/22/2024 7:00:00 AM (UTC)">Oct 22, 2024
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When I travel to see clients and spend entire days discussing investing and the markets, memo ideas often pop up. Last month's visit with clients in Australia is a case in point. We talked about the "sea change" I believe is taking place in interest rates and about the role of credit in portfolios, and in a few cases, this led to the general topic of asset allocation. The result wasn't a lot of new ideas on the subject, but rather a new way to combine old ideas into a unified theory.
Before I proceed, I want to mention that, from time to time in this memo, I'll say "generally," "usually," or "everything else being equal." These caveats are likely applicable to many more sentences and ideas herein, but for the sake of readability, I'm not going to repeat them ad nauseum . In addition, I'm going to use a lot of graphics, as I truly believe one picture is worth a thousand words. Please bear in mind that these representations are intended to be notional, not technically correct.
Asset Classes
From my vantage point, "asset allocation" is a relatively new thing. No one used that phrase when I joined the industry 55 years ago. Structuring portfolios was a pretty simple matter, generally following the classic "60/40" split. Most U.S. investors limited themselves to investing in U.S. stocks and bonds, and there was a time-honored notion that something like 60% equities and 40% bonds represented reasonable diversification.
Today, investors are presented with so many choices – and there's so much emphasis on getting the decision right – that the term "asset allocation" is very prominent, and there are individuals and whole departments dedicated to doing just that. It's their job to decide how to weight the asset classes to be held in a portfolio, meaning asset allocators spend their time on decisions like these:
How much in equities and how much in debt?
How much in stocks and bonds and how much in "alternatives"?
How much in public securities and how much in private assets?
How much in one's home country and how much abroad?
How much of the latter in the developed world and how much in emerging markets?
How much in high quality assets and how much in low quality?
How much in more volatile "high beta" assets and how much in steadier ones?
How much in levered strategies and how much unlevered?
How much in "real assets"?
How much in derivatives?
It's enough to make your head spin. Many investors use computer models to help with these decisions, but the models require inputs regarding expected return, risk, and correlation, and most of these are based on history and thus of questionable relevance to the future. Correlation between asset classes is particularly difficult to predict. It's often a case of garbage in, garbage out (but with the added comfort that comes from using mathematical models).
Ever since coming up with my sea change thesis regarding interest rates two years ago, I've been talking about the increased utility of credit investments. And the more I've done so, the more I've thought about the difference between credit investments and equities. Thus, the first thing I want to mention about my "Australian epiphany" is the unconventional idea that, at bottom, there are only two asset classes: ownership and debt. If someone wants to participate financially in a business, the essential choice is between (a) owning part of it and (b) making a loan to it.
When I moved from Citibank's equity research department to its bond department in 1978, I learned firsthand that this is a matter of night and day. On my new desk, I found a machine called a Monroe 360/65 Bond Trader. If you typed in a bond's interest rate, maturity date, and market price, it would tell you the yield to maturity . . . in other words, what your return would be if you bought the bond at that price and held it to maturity (and it paid). This was revolutionary to me. On the equity side I'd come from, there was no place you could look to find out what your return would be.
This highlighted for me something I've always felt most investors don't grasp viscerally : the essential difference between stocks and bonds . . . that is, between ownership and lending. Investors seem to think of stocks and bonds as two things that fall under the same heading. But the difference is enormous. In fact, ownership and lending have nothing in common:
Owners put their money at risk with no promise of a return. They acquire a piece of a business or other asset and are entitled to their proportional share of any residual that remains after the necessary payments have been made to employees, providers of raw materials, landlords, tax authorities, and, of course, lenders. If there's something left over, it's called profit or cash flow, and the owners have the right to share in whatever part of it is paid out. And if there's profit or cash flow (or the potential for it in the future), the business will have "enterprise value," in which the owners also share.
Lenders typically provide funds to help owners purchase or operate businesses or other assets and, in exchange, are promised periodic interest and the repayment of principal at the end. The relationship between borrower and lender is contractual, and the resulting return is known in advance as described above, again assuming the borrower makes the promised payments when due. That's why this kind of investing is called "fixed income" – the income is fixed. For the purposes of this memo, however, it might help to think of it as "fixed outcome" investing.
This isn't a difference in degree; it's a difference in kind. Ownership assets (things like common stocks, whole companies, real estate, private equity, and real assets) and debt (bonds, loans, mortgage backed securities, and other streams of promised payments) should be thought of as entirely different, not variations on a theme. They have different characteristics and potential, and the choice between them is one of the most basic things investors must decide.
The Essential Choice
At the outset of this memo, I listed some of the decisions that comprise the asset allocation process. But how can those decisions be approached? What's the framework for making them?
The next piece that clicked into place in my thinking "down under" was with regard to the basic characteristics of a portfolio. In my opinion, one decision matters more than – and should set the basis for – all the other decisions in the portfolio management process. It's the selection of a targeted "risk posture," or the desired balance between aggressiveness and defensiveness. The essential decision in investing is how much emphasis one should put on preserving capital and how much on growing it. These two things are mostly mutually exclusive:
Insistence on preserving capital – or, secondarily, on limiting the portfolio's volatility – calls for an emphasis on defense, which precludes pursuing maximum growth.
Correspondingly, a decision to strive to maximize growth requires an emphasis on offense, meaning preservation of capital and steadiness must be sacrificed to some degree.
It's one or the other. You can't simultaneously emphasize both preservation of capital and maximization of growth, or defense and offense. This is the fundamental, inescapable truth in inve