Sunday, January 17, 2010

Howard Marks: Touchstones

Touchstones
http://www.oaktreecapital.com/memo.aspx

by Howard Marks, Chairman, Oaktree Fund | November 10, 2009

In the two-plus years since the onset of the financial crisis, it's been a regular theme of mine that we should look back, identify the causes and learn from them. I've tackled this assignment in a number of memos and a variety of ways. Now, despite the fact that you've heard much of this from me before, I'm going to try to pull it all together, using the quotations, adages and images that I feel best capture the essence of what we've been through. When I think back, these are the ones that stand out.

"Greed Is Good"

There's no debating which line from the film Wall Street is the most memorable. It's hard to forget the image of slicked-back takeover artist Gordon Gekko urging on his troops, invoking the positive power of self-interest. What he meant by "greed is good," of course, was that greed— or self-interest, or the profit motive— is what drives people and companies operating in a free— market setting to strive for more and better, and thus to work hard and optimally allocate resources. It's the force that motivates Adam Smith's "invisible hand" and carries economies to increased output and higher standards of living.

Among the many pendulum-like phenomena we occasionally witness is the swing in people's willingness to rely on the free market. First they trust the market to come up with solutions. Then the shortcomings of those solutions are laid bare and there's a call for regulation. Then the folly of government involvement becomes evident and people want the free market back, and so forth. Because neither extreme is perfect, the oscillation between them goes on. Governments can't run economies or companies. But it's equally true that in a free market, the rules will occasionally be stretched and participants harmed.

In a free market, things will inevitably go past the optimal to the extreme. When they swing back, the retreat can be painful. Thus, if we're going to rely on the market to settle things, we have to be willing to accept the consequences.

In the pre-crisis years, the free market was revered and deferred to, and regulation was thought of as little more than a potential impediment to the market's processes. (An article I can't locate in my pile of clippings beautifully explained the dearth of government action: "That's the kind of regulation you get from an administration that doesn't believe in regulation".) That attitude permitted financial institutions to take actions and bear risks that turned out to be unwise, unprofitable and unsustainable. Their strategies took them to the brink of disaster in 2008.

In a truly free market, Bear Stearns, Merrill Lynch, Citibank, AIG, Fannie Mae, Freddie Mac and others likely would have gone bankrupt. Those bankruptcies would have been quite instructive, but also quite painful. If the world is unwilling to live with such lessons from time to time— and if some institutions are considered to be "too big to fail" for society's purposes— then free markets and self-interest have to be restrained. Greed may be good, but it can be permitted to run free only up to a point.

Nothing's More Risky Than A Widespread Belief That There Is No Risk

The recent crisis came about primarily because investors partook of novel, complex and dangerous things, in greater amounts than ever before. They took on too much leverage and committed too much capital to illiquid investments. Why did they do these things? It all happened because investors believed too much, worried too little, and thus took too much risk. In short, they believed they were living in a low-risk world.

In 2006 and early 2007, for instance, we heard a lot about the "wall of liquidity" that was coming toward us from China and the oil producing countries, a flow that could be counted on to provide capital and raise asset prices non-stop. Likewise, we were told (a) the Fed had tamed the business cycle through its adroit management, (b) securitization, tranching and disintermediation had reduced risk by putting it where it could best be handled, and (c) the "Greenspan put" could always be counted on to bail out investors who made mistakes. These and other things were said to have lowered the risk level worldwide.

Belief that risk has been banished is a key element in allowing people to engage in practices they would otherwise view as risky, and in permitting assets to be bid up to prices that would clearly be too high in a world perceived to involve risk. …former Fed Chairman Paul A. Volcker noted that one of the causes of the financial crisis "was the ultimately explosive combination of compensation practices that provided enormous incentives to take risks" just as new financial innovations "seemed to offer assurance— falsely, as it turned out— that those risks had been diffused". (The Wall Street Journal, September 18, 2009)

Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system. To paraphrase a saying about the usefulness of bankruptcy, fear of loss is to capitalism as fear of hell is to Catholicism. Worry keeps risky loans from being made, companies from taking on more debt than they can service, portfolios from becoming overly concentrated, and unproven schemes from turning into popular manias. When worry and risk aversion are present as they should be, investors will question, investigate and act prudently. Risky investments either won't be undertaken or will be required to provide adequate compensation in terms of anticipated return.

But only when investors are sufficiently risk averse will markets offer adequate risk premiums. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital, and the financial system will become precarious. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety.

For a market to function, those who invest and lend in that market must believe that their money is actually at risk. (President Obama, September 14, 2009) Clearly, in the months and years leading up to the crisis, few participants worried as much as they're supposed to.

Soros's Theory Of Reflexivity

Some of the biggest problems arise because market participants think of their environment as a static arena in which they act. What they miss— to their frequent detriment— is that their actions alter the environment, causing the results to differ from their expectations. George Soros has written and spoken most articulately about the ability of investors' actions to change the environment. He calls this process "reflexivity."

The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect.

When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy…
(George Soros, MIT Department of Economics World Economy Laboratory Conference, Washington, D.C., April 26, 1994)

My son Andrew, now starting his investment career, has provided an illustration of reflexivity at work that's clear and topical. For several years prior to the crisis, the desire for high returns with low risk (what else is new?) created strong demand for mortgage-based investment products such as RMBS and CDOs. Underpinning it all was the fact that there had never been a nationwide decline in home prices, and thus participants were confident that geographic diversification would render levered mortgage pools safe, warranting triple-A ratings for most of the resulting securities.

Rising demand for these products required an increasing volume of underlying mortgages. This need caused lending standards to be weakened and loans to be provided to home buyers with dubious creditworthiness. Easy financing allowed buyers to bid up home prices to levels that exceeded the homes' realistic values and made it tough for borrowers to make their mortgage payments.

When the perpetual-motion machine of house appreciation ground to a halt in 2007, the combination of too-high prices and record mortgage defaults resulted in the first nationwide decline in home prices. Thus, in the end, the belief that an asset was safe led to investor behavior that made it unsafe. That's reflexivity.

In 2003-07, as described above, investors considered the world a low-risk place. Thus they rushed to buy assets they found attractive, borrowing in order to buy more when their own capital was exhausted. They expected purchases made with cheap leverage to produce high profits with low risk. But their buying drove up both the cost of the assets and the riskiness of the environment, transforming their "low-risk" strategies into high-risk ones. The consequences have become clear.

Greenspan And Bubbles

One of the most obvious ways in which investors change the environment is through the creation of asset bubbles, like the one that popped in the summer of 2007. In a process that invariably looks silly after the fact, they reach the conclusion that an investment is a sure winner, usually on the basis of simplistic platitudes that simply can't hold up under scrutiny. These include "Internet stocks must rise because these companies are going to change the world," "real estate (or gold) is a good hedge against inflation," "home prices can never decline nationwide," "oil will appreciate because it's being consumed faster than it's being found," and "alternative investments (or hedge funds or private equity funds) hold the key to meeting investment goals". Because of the strength attributed to these platitudes, investors go on to conclude that the investments they support will be profitable regardless of the price at which they're undertaken.

But how can this be right? It's not possible that something can be a good investment regardless of the price paid. But when a logical-seeming platitude is adopted by the stampeding herd, that belief is the result. That's how we get bubbles.

Bubble thinking is irrational, given that it's built on a belief that there's no price too high. This goes on to manifest itself in a variety of ways. In the 1970s, when hyper-inflation was rampant and interest rates were astronomical, people concluded that no matter the interest rate paid, borrowing to buy "inflation protected" assets like real estate would be profitable. That's bubble thinking.

In my forty-year career, I've seen bubbles in growth stocks, small stocks, oil stocks, emerging market stocks and tech stocks, as well as such surefire winners as silver, homes and buyouts. In each instance, there was a logical underlying rationale for the desirability of the subject assets, but people overlooked the possibility that bubble thinking had raised prices to dangerous levels. Alan Greenspan greatly influenced economic and market developments during his term as Fed Chairman from 1987 to 2006, and his record on the subject of bubbles was poor.

He set the world on its ear in 1996 by railing against "irrational exuberance" as the Dow Jones Index soared past the 6,000 level, but he was quiet thereafter, rationalizing appreciation well beyond 10,000 based on 'gains in productivity'. Here's his position on bubbles:

… bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. (June 17, 1999)

it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity— the very outcome we would be seeking to avoid. Prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy … we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact… . the idea that the collapse of a bubble can be softened by pricking it in advance is almost surely an illusion.
(August 30, 2002)

Thus it was his view that (a) bubbles can only be detected in retrospect, not as they occur, (b) even if detected, bubbles are hard to deflate benignly, (c) rather than deflate them, bubbles can be managed, and (d) deflating bubbles isn't the job of the Fed. This relaxed position on bubbles can easily be seen as having abetted their growth. For example:

… testimony before Congress last week refutes, once and for all, the existence of an alleged housing market "bubble," said chief economists of the National Association of Home Builders… . "The time has come to put this issue to rest," said NAHB Chief Economist David Seiders. "The nation's home builders have said it, the Realtors have said it, and now Alan Greenspan has said it once again, in no uncertain terms: there is no such thing as a current or impending house price bubble".

Asked about the issue during his testimony, Greenspan said,
"We've looked at the bubble question and we've concluded that it is most unlikely". He attributed recent "sizeable gains" in home prices to "the effects on demand of low mortgage rates, immigration and shortages of buildable land". (Business Wire, July 22, 2002)

Ignoring bubbles is a special case of ignoring risk in general. The philosopher George Santayana is famous for having said, "Those who cannot remember the past are condemned to repeat it". Likewise, those who fail to learn from past bubbles are bound to suffer in the bursting of new ones.

The More You Bet, The More You Win When You Win

In the years just prior to the crash, obliviousness to risk encouraged numerous forms of risky behavior. [[Incresingly so, since it is human nature to always want to 'top' your latest 'coup' or that of someone else!: normxxx]] One of the greatest was the use of leverage to increase returns, a phenomenon that became widespread. People make investments on the basis of positive expected returns. When the cost of borrowing is below the expected return, using leverage appears certain to magnify the gain. Thus the Las Vegas maxim that heads this section comes into play, and it's that kind of thinking that gives leverage its seductive power.

But there's so much more to leverage than that, and unfortunately the rest is learned only when things go badly. Leverage doesn't make an investment better; it merely magnifies the gains and losses. Leverage is what James Grant of Grant's Interest Rate Observer calls "money of the mind," meaning it can vanish if the lender is able to take his money back. And any combination of fundamental difficulty, falling asset prices, reduced market liquidity, collateral value tests and margin calls can be the ruination of investors employing leverage. That's what befell many in the fourth quarter of 2008.

In 2003-07, interest rates brought low by the Fed, modest demands for risk premiums on the part of unworried investors, and financial institutions' competition to lend conspired to make low-cost leverage readily available. That cheap financing (a) convinced people that high leverage was the route to increased returns (even from low-yielding underlying investments), (b) armed all parties for a bidding war for assets, and (c) made people rush to borrow and buy before the river of financing ran dry. The result was a buying spree of massive proportions, the bill for which— in terms of debt maturities, often unpayable— will come due in the next few years.

Like just about everything else in investing, leverage is neither good nor bad per se. Used at the right time, in judicious amounts, to purchase low-priced assets, it's a good thing. But that's not the story of the pre-crisis years. And that's a big reason for the trouble we've had since.

"Risk Means More Things Can Happen Than Will Happen"

The above quote from Elroy Dimson of the London Business School helps bring risk into focus. Risk has been the subject of excessive complication and sophistication, but Dimson's simple formulation makes clear what it's all about. Investing consists entirely of dealing with the future. To do that, people must form opinions about what lies ahead. But few things are more potentially harmful than projections. I've collected a lot of quotations on this subject. Here are my two favorites, but I have a million more:

We have two classes of forecasters: Those who don't know— and those who don't know they don't know.
John Kenneth Galbraith

It's frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people
who have faith that they know exactly what's going on.
Amos Tversky

One of the errors committed in 2003-07— forming a cornerstone of the crisis— consisted of believing too much in the ability to predict the future. Investors, risk managers, financial institution executives, rating agencies and regulators trusted forecasts, extrapolations and computer models. [[Indeed, above all, computer models employing increasingly arcane and sophisticated algoritms which no one understood— except maybe those Wall Street 'quants', ex-rocket scientists and the like mathematical types, completely ignorant of Wall Street and disdainful of anything that had proceded them, fresh out of the best graduate schools— certainly not their Wall Street supervisors and bosses. See "A Demon of Our Own Design" by noted 'quant' Richard Bookstaber. Their event horizon barely extended back to the Long Term Capital Management fiasco.: normxxx]] This made them comfortable with risk, always a dangerous arrangement.

[ Normxxx Here:  And always a sign of the utmost ignorance and hubris— since, above all, risk is the things that can happen that are completely beyond your imagination— such as the value of good securities (and gold) falling because desperate people are selling them to raise desperately needed funds, and the value of garbage rising, because there are simply no buyers, so that they can sport any price.  ]

The "I know" school of investing has received frequent mention in my memos (e.g., "Us and Them," May 7, 2004). Its members— money managers, Wall Street strategists and media pundits— believe that there's a single future, it is knowable in advance, and they're among the people who know it. They're eager to tell you what the future holds, and equally willing to overlook the inaccuracy of their past predictions [[and which were due to minor error(s) which they have since corrected and vastly improved upon: normxxx]]. What they repeatedly ignore is the fact that (a) the future possibilities cover a broad range [[well beyond the abilities of any pundit to conceive, much less calculate: normxxx]], (b) some of them— the "black swans"— can't even be imagined in advance, and (c) even if it's possible to know which one outcome is the most likely, the others have a substantial combined probability of occurring instead.

Thus one key question each investor has to answer is whether he views the future as knowable or unknowable. An investor who feels he knows what the future holds will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth— in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, someone who feels he doesn't know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.

The first group of investors did much better in the years leading up to the crash. But the second group was better prepared when the crash unfolded. And they had more capital available (and more-intact psyches) with which to profit from purchases made at its nadir.

Never Forget The 6'-Tall Man Who Drowned Crossing The Stream That Was 5' Deep On Average

The range of possibilities— the environments with which we must deal— invariably will include some bad ones. We must prepare for them, and the unavoidable prerequisite for doing so is being aware of them. [[Even those of which we cannot possibly conceive!: normxxx]] Following from the section above, the key is to view the future as a range of possibilities, not a reliable point estimate.

How does the successful investor prepare for the uncertain future? By building in what Warren Buffett calls "margin for error" or "margin of safety". It's having this margin that enables us to do okay even when things don't go our way. [[And we can consider the cost of 'lost opportunities' by using such a conservative approach as the insurance premium for not being clobbered in a crash.: normxxx]]

If an investor prepares for a single future and attempts to maximize under the assumption that his view will prove right, he'll be in big trouble if [[when?: normxxx]] it doesn't. The investor who backs off from the 'maximizing' position is likely to do better when negative surprises occur. [[And, in general, far better overall in that famous 'long run'.: normxxx]] Thus it's essential to realize a few things:

•  It's not sufficient to think about surviving "on average"— investment survival has to be achieved every day, under all circumstances.

•  The ability to survive under adverse conditions comes from a portfolio's margin for error.

•  Ensuring sufficient margin for error and attempting to maximize returns are incompatible.


The use of leverage illustrates a special case of the above. Leverage increases the gains if you succeed and the losses if you fail. Thus leverage increases the probability of maximizing under favorable outcomes and reduces your margin of safety under unfavorable ones. In 2008, leveraged loans that ultimately proved to be money-good declined in price for psychological and technical reasons. Loan investors who were able to hold on recovered, but many who had bought with leverage couldn't do so. They drowned in the deep part of the stream.

Chuck Prince On Dancing

A quotation from the former CEO of Citigroup contains just 30 words, but it could serve as a case study regarding the events leading up to the crash:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing. (Charles Prince, July 9, 2007, former chief executive officer (CEO) and chairman of Citigroup)

I suspected in mid-2007 that this quotation would end up being emblematic of the cycle. It's been replayed many times, but usually without the first dozen words. Prince seems to have been more aware of what was going on than people give him credit for. He may have sensed the bank was on thin ice in lending and levering, like the rest. The problem wasn't that he overlooked the danger; the problem was that he felt he had to participate anyway.

One of the dilemmas faced by businesses is that they can conclude that they have no choice but to take part in dangerous behavior. Usually this is because they're unwilling to cede market share [[and, in many if not most cases, their jobs, to angry clients/'investors' who cannot remain 'conservative' while their neighbors are "raking it in".: normxxx]]. On October 5, Leo Strine, Vice Chancellor of the Delaware Court of Chancery, wrote as follows in The New York Times Dealbook:

… the ability of any particular firm to resist imitating the overly risky, but law-compliant behavior of competitors will be compromised to the extent that managers face criticism or even removal for not keeping up with so-called 'industry leaders' whose high, short-term returns have pleased a stock market filled with short-term investors looking for alpha.

In "The Race to the Bottom" (February 14, 2007), I describe the dangerous behavior that providers of capital engage in when the competition becomes heated. The formula is one of the simplest: when there's too much money chasing too few deals, asset prices are driven up, prospective returns are driven down, and risk rises [[astronomically: normxxx]].

Those seven little words— too much money chasing too few deals— represent an absolute death knell for the availability of good returns earned with safety. It should be possible to know when this is the case, as Prince did, but people tend to join in nevertheless. Often this is true because, even if they recognize the danger, they're also aware that "being too far ahead of your time is indistinguishable from being wrong," and they don't want to be out of step.

The way I see it, investors face two main risks: the risk of losing money and the risk of missing out. Although investors should balance the two, in reality this is yet another of those arcs along which the pendulum swings regularly between extremes. The disposition of a market— the position of the pendulum— can be inferred from the behavior of participants regarding these two risks.

In the years just before the crash, encouraged by the purported 'risk-reducers' [[and there are always those 'risk-reducers', which purportedly lower the risk to a vanishingly small amount: normxxx]] described above, investors generally ignored the risk of loss. In those heady times, they feared only missing opportunities, looking too conservative, and losing business. This combination spurred them to employ aggressive strategies, innovative products, leverage and illiquidity. When most people think the worst imaginable outcome is failing to participate fully in gains, the result is risky behavior. They're inevitably reminded that there's worse, but it can take a long time to happen.

"It's Only When the Tide Goes Out That You Find Out Who's Been Swimming Naked"

When I came across the above quotation from Warren Buffett, I borrowed it for "It's All Good" (July 16, 2007) and later devoted an entire memo to it ("The Tide Goes Out," March 18, 2008). Buffett's way of saying things combines brevity, humor and pinpoint accuracy, and this is a great example.

Financial innovation was a major component in building the base for the crisis. As I've said before, popularization of new investment products is possible only in rising markets, with their suspension of skepticism, easy access to money, and dearth of trying moments. On the other hand, innovations are only tested in falling markets, and few pass the ultimate test. Californians' homes may contain construction flaws, but we only learn about them during earthquakes. Likewise, a fatally flawed investment product can easily survive until it's tested in a bear market.

The extensive investment innovation of 2003-07 was driven by the poor performance of stocks in 2000-02 and the low yields available on high grade bonds. A large number of new products and strategies emerged, increasing in popularity in a salutary environment. Few investors were troubled by the products' dependence on high leverage or suddenly commonplace triple-A ratings, or by the fact that they hadn't been tested in tough times.

It's not surprising that bull market developments were defrocked in the tougher times of 2007-08, but it's somewhat shocking how many examples there are. It turned out that:

•  losses on investments involving leverage, illiquidity or risky assets could be much worse than the "worst case" that had been predicted.

•  beta had been confused for alpha, just as leverage had for value added,

•  there was nothing absolute about
"absolute return," and "market neutral" strategies were correlated with the market,

•  the
"golden age of private equity" had been a function of easy money, not bargain purchases,

•  sharing the upside with investment managers isn't sufficient to align their interests with those of their clients, and

•  things that
"should happen" often don't.


While an extreme case, the story of Bernie Madoff presents an apt example of this phenomenon. Madoff's fictitious returns weren't very high, but they were remarkably steady; thus his clients thought of his fund as a high-yielding T-bill. This made it easy for the skilled Ponzi schemer to satisfy the few withdrawal requests with cash from eager new investors. This could have continued ad infinitum if not for the market collapse in 2008. Madoff's investors had complete confidence in him, but they couldn't get money they needed from other funds that had put up gates, or they didn't want to sell other investments that, unlike Bernie's, were showing big losses.

So Madoff received requests for $7 billion of withdrawals, an amount he simply couldn't raise from new suckers, and his nakedness became apparent. The Madoff story exemplifies the ability of ill-founded investments to prosper in bull markets, and the role of bear markets in exposing them. Now that the tide has gone out, many pre-crisis miracles have been exposed as non-value based, overly dependent on prosperity and easy money, pro-cyclical, over-hyped or just plain flawed. Hopefully next time, investors will give more thought to how their bull-market dalliances will fare when the tide goes out.

The Opposite Of A Bubble

On the heels of the lessons regarding the run-up to the crash, the latter part of 2008 provided several lessons about behavior in times of crisis. With the fundamental outlook terrible, psychology depressed and technical conditions featuring a great deal of forced selling, that period represented one of the greatest buying opportunities I've ever seen. I expressed my view that, having been too optimistic before the crash, people were now taking things too far on the downside. It's not easy to resist emotional excesses at highs and lows, but it's by doing so that the best investment decisions can be made:

… it's improbable events that brought on the credit crisis. Lots of bad things happened that had been considered unlikely (if not impossible), and they happened at the same time, to investors who'd taken on significant leverage. So the easy explanation is that the people who were hurt in the credit crisis hadn't been skeptical— or pessimistic— enough. But that [realization] triggered an epiphany: Skepticism and pessimism aren't synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive. ("The Limits to Negativism," October 15, 2008)

The swing of the pendulum to one extreme or another is a constant in the investment world: from optimism to pessimism, from credulous to skeptical, from sanguine to panicked, from wide-open capital markets to windows slammed shut, from more buyers than sellers to more sellers than buyers and, consequently, from overpriced to underpriced. Thus I was thrilled when an article by my friend James Grant provided a quotation that beautifully sums up the end result of this process:

To the English economist Arthur C. Pigou is credited a bon mot that exactly frames the issue. "The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant". (The Wall Street Journal, September 19, 2009)

Optimism thrives in bubbles. That's what they're built on, with optimism and rising prices reinforcing each other. Likewise, crises are brought on by an extreme turn toward pessimism. Falling prices and pessimism contribute to each other on the way down. In the years just before the crash, no view was considered too optimistic. There were few skeptics around to point out that a notion might be too good to be true.

And then, as Pigou says, the opposite became true post-Lehman Brothers. There was no scenario of which someone wouldn't suggest, "But what if it's worse than that"? Now no idea was considered too negative to be true.

The error is clear. The herd applies optimism at the top and pessimism at the bottom. Thus, to benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom. Pigou makes an excellent additional point.

Bubbles usually build gradually over time, the result of a steady accretion of logical bases, favorable developments, high returns being achieved, platitudes taken to extremes, willing suspension of disbelief, rising optimism and the recruitment of new buyers. But when the bubble's faulty underpinnings are exposed, it tends to collapse in a rush. The excess of pessimism does arrive quickly, "born a giant". Or as my partner Sheldon Stone puts it, "the air goes out of the balloon a lot faster than it went in".

A recent report by Ian Kennedy and Richard Riedel of Cambridge Associates, entitled "Behavioral Risk," provides an excellent explanation for this process and describes its effect:

[During good times,] we suffer from what James Montier characterizes as "the illusion of control: the belief that if things go wrong, we will be able to sort them out". When that illusion is shattered during a selling panic, we don't know where to turn or what to think… .

What happens when we humans (and, indeed, other animals) are slammed by shock? Unless trained otherwise, our instincts tell us to retreat, conserve, seek the comparative safety of groups, and search for a path out of danger. These are ancient survival instincts, hard-wired. Slammed by financial shock, the same instincts result in heightened risk aversion (gimme cash!), a dramatic foreshortening of our normal investment time horizon, an overwhelming impulse to flee with the herd, a tendency to extrapolate current trends all the way to Armageddo.

In times of crisis, when risk aversion spikes, panicked investors tend to stampede for the exits. The temptation to join them is well-nigh irresistible because the whole financial edifice seems to be collapsing. Carefully wrought models are rendered irrelevant overnight, as correlations converge on 1.0, and
"fat tail" risk wags the dog… .

When markets are falling, we instinctively feel that risk is rising, and when markets are rising, that risk is ebbing. In the short term, this instinct may be right since markets often run on momentum in the short run. But for long-term investors it is dead wrong… . As equity markets plummet, investors' risk aversion rises even as the fundamental risk is in fact declining.

In other words, our instincts and emotions conspire to make us do the wrong thing at the wrong time: to trust at the top and worry at the bottom, and to think something's riskier at $10 than it was at $100, as if the emotion-fed price decline is correct in suggesting that something's wrong.

Buy Low, Sell High

Of all the adages that bear on the events of this extreme cycle we're living through, the simple one just above— probably the first one any of us learned— is still the most important. In my early years in this business, people who spent all their time on security selection were told that asset allocation can be more important. I'd like to nominate a third candidate for primacy: countercyclical behavior. Consider any intermediate-term period of 3-5 years or so in which the market pendulum makes a significant swing (and that's about all of them).

The period 2004-08 presents a good example. Individual security selection had limited impact on the return from a diversified portfolio. Asset allocation mattered much more, but primarily because it determined your posture with regard to the market's swing. By far the most pivotal thing is whether your investing was anti-cyclical or pro-cyclical. Did you buy more at the bottom or more at the top? Did you invest defensively at the top and aggressively at the bottom, or vice versa? In other words, did you buy low and sell high, or buy high and sell low?

The Cambridge study describes the importance of resisting the cycle and acting counter to it. It also outlines the difficulty of doing so, and some of the reasons. But it is the most important thing. Did you participate in the errors of 2004-08 or resist? That's the key.

Resisting— and thereby achieving success as a contrarian— isn't easy. Things combine to make it difficult, including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That's why it's essential to remember that "being too far ahead of your time is indistinguishable from being wrong".) Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one— especially as price moves against you— it's challenging to be a lonely contrarian.

A few things that can help, however. First, after even a little time spent in the investment business, everyone should know that the herd is usually wrong at the extremes and pays dearly for its error. Second, some contrarians have records that are very impressive. And third, an accurate reading of investor mood and behavior— perceptive inference of danger or opportunity based on what others are doing in the market— can give investors a good leg up toward being effective contrarians. I say we never know where we're going, but we sure as heck ought to know where we are. The cycle isn't unknowable or unbeatable. Touchstones like those enumerated above are there for everyone to see, but few people take full advantage. The key is to be among those who do.

The philosopher Hannah Arendt wrote:

… no matter how much we may be capable of learning from the past, it will not enable us to know the future. (The Origins of Totalitarianism, 1951)

We cannot know what the future holds, and history cannot tell us. But awareness of that limitation is a key lesson in itself. Mastering it increases our likelihood of investment success.

November 10, 2009

'

Memo To Oaktree Clients: "So Much That's False And Nutty"


By Howard Marks, President, Oaktree | 29 November 2009

As reported in The New York Times of May 5, Warren Buffett told the crowd at this year's Berkshire Hathaway annual meeting:
There is so much that's false and nutty in modern investing practice and modern investment banking. If you just reduced the nonsense, that's a goal you should reasonably hope for.

As we look back at the causes of the crisis approaching its second anniversary— and ahead to how investors might conduct themselves better in the future— Buffett's simple, homespun advice holds the key, as usual. I agree that investing practice went off the rails in several fundamental ways. Perhaps this memo can help get it back on.

The Lead-Up: Progress And Missteps

Memory dims with the passage of time, but when I think back to the investment arena I entered forty-plus years ago, it seems very different from that of 2003-07. Institutional investing was done mainly by bank investment departments (like the one I was part of), insurance companies and investment counselors— a pretty dull bunch. And as I like to point out when I speak to business school classes, "famous investor" was an oxymoron— few investment managers were well known, chosen for magazine covers or listed among the top earners.

There were no swaps, index futures or listed options. Leverage wasn't part of most institutional investors' arsenal … or vocabulary. Private equity was unknown, and hedge funds were too few and outré to matter. Innovations like quantitative investing and structured products had yet to arrive, and few people had ever heard of "alpha."

Return aspirations were modest. Part of this likely was attributable to the narrow range of available options: for the most part stocks and bonds. Stocks would average 9-10% per year, it was held, but we might put together a portfolio that would do a little better. And the admissible bonds were all investment grade, yielding moderate single digits.

We wanted to earn a good return, limit the risks, beat the Dow and our competitors, and retain our clients. But I don't remember any talk of "maximization," or anyone trying to "shoot the lights out". And by the way, no one had ever heard of performance fees. Quite a different world from that of today. Perhaps it would constitute a service if I pulled together a list of some of the developments since then:

• In the mid-1960s, growth investing was invented, along with the belief that if you bought the stocks of the "nifty-fifty" fastest-growing companies, you didn't have to worry about paying the right price.

• The first of the investment boutiques was created in 1969, as I recall, when highly respected portfolio managers from a number of traditional firms joined together to form Jennison Associates. For the first time, institutional investing was sexy.

• We started to hear more about investment personalities. There were the
"Oscars" (Schafer and Tang) and the "Freds" (Carr, Mates and Alger)— big personalities with big performance, often working outside the institutional mainstream.

• In the early 1970s, modern portfolio theory began to seep from the University of Chicago to Wall Street. With it came indexation, risk-adjusted returns, efficient frontiers and risk/return optimization.

• Around 1973, put and call options escaped from obscurity and began to trade on exchanges like the Chicago Board Options Exchange.

• Given options' widely varying time frames, strike prices and underlying stocks, a tool for valuing them was required, and the Black-Scholes model filled the bill.

• A small number of leveraged buyouts took place starting in the mid-1970s, but they attracted little attention.

• 1977-79 saw the birth of the high yield bond market. Up to that time, bonds rated below investment grade couldn't be issued. That changed with the spread of the argument— associated primarily with Michael Milken— that incremental credit risk could responsibly be borne if offset by more-than-commensurate yield spreads.

• Around 1980, debt securitization began to occur, with packages of mortgages sliced into securities of varying risk and return, with the highest-priority tranche carrying the lowest yield, and so forth. This process was an example of disintermediation, in which the making of loans moved out of the banks; 25 years later, this would be called the shadow banking system.

• One of the first
"quant" miracles came along in the 1980s: portfolio insurance. Under this automated strategy, investors could ride stocks up but avoid losses by entering stop-loss orders if they fell. It looked good on paper, but it failed on Black Monday in 1987 when brokers didn't answer their phones.

• In the mid- to late 1980s, the ability to borrow large amounts of money through high yield bond offerings made it possible for minor players to effect buyouts of large, iconic companies, and
"leverage" became part of investors' everyday vocabulary.

• When many of those buyouts proved too highly levered to get through the 1990 recession and went bust, investing in distressed debt gained currency.

• Real estate had boomed because of excessive tax incentives and the admission of real estate to the portfolios of S&Ls, but it collapsed in 1991-92. When the Resolution Trust Corporation took failed properties from S&Ls and sold them off,
"opportunistic" real estate investing was born.

• Mainstream investment managers made the big time, with Peter Lynch and Warren Buffett becoming famous for consistently beating the equity indices.

• In the 1990s, emerging market investing became the hot new thing, wowing people until it took its knocks in the mid— to late 1990s due to the Mexican peso devaluation, Asian financial crisis and Russian debt disavowal.

• Quant investing arrived, too, achieving its first real fame with the success of Long— Term Capital Management. This Nobel Prize-laden firm used computer models to identify fixed income arbitrage opportunities. Like most other investment miracles, it worked until it didn't. Thanks to its use of enormous leverage, LTCM melted down spectacularly in 1998.

• Investors' real interest in the last half of the '90s was in common stocks, with the frenzy accelerating but narrowing to tech-media-telecom stocks around 1997 and narrowing further to Internet stocks in 1999. The
"limitless potential" of these instruments was debunked in 2000, and the equity market went into its first three-year decline since the Great Crash of '29.

• Venture capital funds, blessed with triple-digit returns thanks to the fevered appetite for tech stocks, soared in the late 1990s and crashed soon thereafter.

• After their three-year slump, the loss of faith in common stocks caused investors to shift their hopes to hedge funds—
"absolute return" vehicles expected to make money regardless of what went on in the world.

• With the bifurcation of strategies and managers into
"beta-based" (market-driven) and "alpha-based" (skill-driven), investors concluded they could identify managers capable of alpha investing, emphasize it, perhaps synthesize it, and "port" or carry it to their portfolios in additive combinations.

• Private equity— sporting a new label free from the unpleasant history of
"leveraged buyouts"— became another popular alternative to traditional stocks and bonds, and funds of
$20 billion and more were raised at the apex in 2006-07.

• Wall Street came forward with a plan to package prosaic, reliable home mortgages into collateralized debt obligations— the next high-return, low-risk free lunch— with help from tranching, securitization and selling onward.

• The key to the purported success of this latest miracle lay in computer modeling. It quantified the risk, assuming that mortgage defaults would remain uncorrelated and benign as historically had been the case. But because careless mortgage lending practices unknowingly had altered the probabilities, the default experience turned out to be much worse than the models suggested or the modelers thought possible.

• Issuers of collateralized loan obligations bought corporate loans using the same processes that had been applied to CDOs. Their buying facilitated vast issuance of syndicated bank loans carrying low interest rates and few protective covenants, now called leveraged loans because the lending banks promptly sold off the majority.

• Options were joined by futures and swaps under a new heading: derivatives. Heralded for their ability to de-risk the financial system by shifting risk to those best able to bear it, derivatives led to vast losses and something new: counterparty risk.

• The common thread running through hedge funds, private equity funds and many other of these investment innovations was incentive compensation. Expected to align the interests of investment managers and their clients, in many cases it encouraged excessive risk taking.

• Computer modeling was further harnessed to create
"value at risk" and other 'risk management'
[[an oxymoron if ever there was one— not to be confused with 'risk containment' or 'risk mitigation': normxxx]] tools designed to 'quantify' how much would be lost if the investment environment soured. This fooled people into thinking risk was under control— a belief that, if acted on, has the potential to vastly increase risk.

At the end of this progression we find an institutional investing world that bears little resemblance to the quaint cottage industry with which the chronology began more than forty years ago. Many of the developments served to increase risk or had other negative implications, for investors individually and for the economy overall. In the remainder of this memo, I'll discuss these trends and their ramifications.

Something For Everyone

One thing that caused a lot of people to lose money in the crisis was the popularization of investing. Over the last few decades, as I described in "The Long View" (January 2009), investing became widespread. "Less than 10% of adults owned stocks in the 1950s, in contrast to 40% today". (Economics and Portfolio Strategy, June 1, 2009). Star investors became household names and were venerated. "How-to" books were big sellers, and investors graced the covers of magazines. Television networks were created to cover investing 24/7, and Jim Cramer and the "Money Honey" became celebrities in their own right.

It's interesting to consider whether this "democratization" of investing represented progress, because in things requiring special skill, it's not necessarily a plus when people conclude they can do them unaided. The popularization— with a big push from brokerage firms looking for business and media hungry for customers— was based on success stories, and it convinced people that "anyone can do it". Not only did this overstate the ease of investing, but it also vastly understated the danger. ("Risk" has become such an everyday word that it sounds harmless— as in "the risk of underperformance" and "risk-adjusted performance". Maybe we should switch to "danger" to remind people what's really involved.)

To illustrate, I tend to pick on Wharton Professor Jeremy Siegel and his popular book "Stocks for the Long Run." Siegel's research was encyclopedic and supported some dramatic conclusions, perhaps foremost among them his showing that there's never been a 30-year period in which stocks didn't outperform cash, bonds and inflation. This convinced a lot of people to invest heavily in stocks. But even if his long-term premise eventually holds true, anyone who invested in the S&P 500 ten years ago— and is now down 20%— has learned that 30 years can be a long time to wait.

The point is that not everyone is suited to manage his or her own investments, and not everyone should take on uncertain investments. The success of Bernard Madoff's Ponzi scheme shows that even people who are wealthy and presumed sophisticated can overlook risks. Might that be borne in mind the next time around?

At Ease With Risk

Risk is something every investor should think about constantly. We know we can't expect to make money without taking chances. The reason's simple: if there was a risk-free way to make good money— that is, a path to profit free from downside— everyone would pursue it without hesitation. That would bid up the price, bring down the return and introduce the risk that accompanies elevated prices.

So yes, it's true that investors can't expect to make much money without taking risk. But that's not the same as saying risk taking is sure to make you money. As I said in "Risk" (January 2006), if risky investments always produced high returns, they wouldn't be risky.

The extra return we hope to earn for holding stocks rather than bonds is called an equity risk premium. The additional promised yield on high yield bonds relative to Treasurys is called a credit risk premium. All along the upward-sloping capital market line, the increase in potential return represents compensation for bearing incremental risk. Except for those people who can generate "alpha" or access alpha managers, investors shouldn't plan on getting added return without bearing incremental risk. And for doing so, they should demand risk premiums.

But at some point in the swing of the pendulum, people usually forget that truth and embrace risk taking to excess. In short, in bull markets— usually when things have been going well for a while— people tend to say, "Risk is my friend. The more risk I take, the greater my return will be. I'd like more risk, please."

The truth is, risk tolerance is antithetical to successful investing. When people aren't afraid of risk, they'll accept risk without being compensated for doing so … and risk compensation will disappear. This is a simple and inevitable relationship. When investors are unworried and risk-tolerant, they buy stocks at high p/e ratios and private companies at high EBITDA multiples, and they pile into bonds despite narrow yield spreads and into real estate at minimal "cap rates."

In the years leading up to the current crisis, it was "as plain as the nose on your face" that prospective returns were low and risk was high. In simple terms, there was too much money looking for a home, and too little risk aversion. Valuation parameters rose and prospective returns fell, and yet the amount of money available to managers grew steadily. Investors were attracted to risky deals, complex structures, innovative transactions and leveraged instruments. In each case, they seemed to accept the upside potential and ignore the downside.

There are few things as risky as the widespread belief that there's no risk, because it's only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums. Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we'll continue to be alert for times when they don't.

Embracing Illiquidity

Among the risks faced by the holder of an investment is the chance that if liquidity has dried up at a time when it has to be sold, he'll end up getting paid less than it's worth. Illiquidity is nothing but another source of risk, and it should be treated no differently:

• All else being equal, investors should prefer liquid investments and dislike illiquidity.

• Thus, before making illiquid investments, investors should ascertain that they're being rewarded for bearing that risk with a sufficient return premium.

• Finally, out of basic prudence, investors should limit the proportion of their portfolios committed to illiquid investments. There are some risks investors shouldn't take regardless of the return offered.


But just as people can think of risk as a plus, so can they be attracted to illiquidity, and for basically the same reason. There is something called an illiquidity premium. It's the return increment investors should receive in exchange for accepting illiquidity. But it'll only exist if investors prefer liquidity. If they're indifferent, the premium won't be there.

Part of the accepted wisdom of the pre-crisis years was that long-term institutional investors should load up on illiquid investments, capitalizing on their ability to be patient by garnering illiquidity premiums. In 2003-07, so many investors adopted this approach that illiquidity premiums became endangered. For example, as of the middle of 2008, the average $1 billion-plus endowment is said to have had investments in and undrawn commitments to the main illiquid asset classes (private equity, real estate and natural resources) equal to half its net worth. Some had close to 90%.

The willingness to invest in locked-up private investment funds is based on a number of "shoulds." Illiquid investments should deliver correspondingly higher returns. Closed-end investment funds should call down capital gradually. Cash distributions should be forthcoming from some funds, enabling investors to meet capital calls from others. And a secondary market should facilitate the sale of positions in illiquid funds, if needed, at moderate discounts from their fair value. But things that should happen often fail to happen. That's why investors should view potential premium returns skeptically and limit the risk they bear, including illiquidity.

Comfortable With Complexity

Investors' desire to earn money makes them willing to do things they haven't done before, especially if those things seem modern and sophisticated. Technological complexity and higher math can be seductive in and of themselves. And good times and rising markets encourage experimentation and erase skepticism. These factors allow Wall Street to sell innovative products in bull markets (and only in bull markets). But these innovations can be tested only in bear markets … and invariably they are.

Many of the investment techniques that were embraced in 2003-07 represented quantitative innovations, and people seemed to think of that as an advantage rather than a source of potential risk. Investors were attracted to black-box quant funds, highly levered mortgage securities critically dependent on computer models, alchemical portable alpha, and risk management based on sketchy historical data. The dependability of these things was shaky, but the risks were glossed over. As Alan Greenspan wrote in The Wall Street Journal of March 11:

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

Warren Buffett put it in simpler terms at this year's Berkshire meeting. "If you need a computer or a calculator to make the calculation, you shouldn't buy it". And Charlie Munger added his own slant: "Some of the worst business decisions I've ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you, but it doesn't. They teach that in business schools because, well, they've got to do something."

To close on this subject, I want to share a quote I recently came across from Albert Einstein. I've often argued that the key to successful investing lies in subjective judgments made by experienced, insightful professionals, not machinable processes, decision rules and algorithms. I love the way Einstein put it:

Not everything that can be counted counts, and not everything that counts can be counted.

Relying On Ratings

My memos on the reasons for the crisis, like "Whodunit" (February 2008), show that there's more than enough blame to go around and lots of causes to cite. But if you boil it down, there was one indispensable ingredient in the process that led to trillions of dollars of losses: misplaced trust in credit ratings. The explanation is simple:

• Competitive pressure for profits caused financial institutions to try to keep up with the leaders. As is normal in good times, the profit leaders were those who used the most leverage.

• Thus institutions sought to maximize their leverage, but the rules required that the greatest leverage be used only with investments rated triple-A.

• A handful of credit rating agencies had been designated by the government as Nationally Recognized Statistical Rating Organizations, despite their highly imperfect track records.

• The people who guard the financial henhouse often have a tough time keeping up with the foxes' innovations. Whereas traditional bond analysis was a relatively simple matter, derivatives and tiered securitizations were much more complex. This allowed rating agency employees to be manipulated by the investment banks' quantitatively sophisticated and highly compensated financial engineers.

• The rating agencies proved too naïve, inept and/or venal to handle their assigned task.

• Nevertheless, financial institutions took the ratings at face value, enabling them to pursue the promise of highly superior returns from supposedly riskless, levered-up mortgage instruments. This deal clearly was too good to be true, but the institutions leapt in anyway.


It all started with those triple-A ratings. For his graduation from college this year, Andrew Marks wrote an insightful thesis on the behavior that gave rise to the credit crisis. I was pleased that he borrowed an idea from "Whodunit": "if it's possible to start with 100 pounds of hamburger and end up selling ten pounds of dog food, 40 pounds of sirloin and 50 pounds of filet mignon, the truth-in-labeling rules can't be working". That's exactly what happened when mortgage-related securities were rated.

Investment banks took piles of residential mortgages— many of them subprime— and turned them into residential mortgage-backed securities (RMBS). The fact that other tranches were subordinated and would lose first allowed the rating agencies to be cajoled into rating a lot of RMBS investment grade. Then RMBS were assembled into collateralized debt obligations, with the same process repeated. In the end, heaps of mortgages— each of which was risky— were turned into CDO debt, more than 90% of which was rated triple-A, meaning it was supposed to be almost risk-free.

John Maynard Keynes said "… a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware." Speculators who bought the low end of the CDO barrel with their eyes open to the risk suffered total losses on a small part of their capital. But the highly levered, esteemed investing institutions that accepted the higher ratings without questioning the mortgage alchemy lost large amounts of capital, because of the ease with which they'd been able to lever holdings of triple-A and "super-senior" CDOs. Ronald Reagan said of arms treaties, "Trust, then verify". If only financial institutions had done the same.

The rating agencies were diverted from their mission by a business model that made them dependent on security issuers for their revenues. This eliminated their objectivity and co-opted them into the rating-maximization process. Regardless of that happening, however, it's clear that the stability of our financial institutions never should have been allowed to rely so heavily on the competence of a few for-profit (and far-from-perfect) rating agencies. In the future, when people reviewing the crisis say, "If only they had … ," the subject will often be credit ratings. Bottom line: investors must never again abdicate the essential task of assessing risk. It's their number-one job to perform thorough, skeptical analysis.

The More You Bet

If I had to choose a single phrase to sum up investor attitudes in 2003-07, it would be the old Las Vegas motto: "The more you bet, the more you win when you win". Casino profits ride on getting people to bet more. In the financial markets just before the crisis, players needed no such encouragement. They wanted to bet more, and the availability of leverage helped them do so.

One of the major trends embedded in the chronology on pages two and three was toward increasing the availability of leverage. Now, I've never heard of any of Oaktree's institutional clients buying on margin or taking out a loan to make investments. It might not be considered "normal" for fiduciaries, and tax-exempt investors would have to worry about Unrelated Business Taxable Income.

None of us go out and buy Intel chips, but we've all seen commercials designed to get us to buy products with "Intel inside." In the same way, investors became increasingly able to buy investment products with leverage inside … that is, to participate in levered strategies rather than borrow explicitly to make investments. Think about these elements from my earlier list of investment developments:

• Investors who would never buy stocks on margin were able to invest in private equity funds that would buy companies on leverage of four times or more.

• The delayed and irregular nature of drawdowns caused people who had earmarked
$100 for private investment funds to make commitments totaling $140.

• Options, swaps and futures— in fact, many derivatives— are nothing but ways for investors to access the return on large amounts of assets with little money down.

• Many hedge funds used borrowings or derivatives to access the returns on more assets than their capital would allow them to buy.

• When people wanted to invest
$100 in markets with skill-derived return bolted on, "portable alpha" had them invest $90 in hedge funds with perceived alpha and the rest in futures covering $100 worth of the passive market index. This gave them a stake in the performance of $190 of assets for every $100 of capital.

Clearly, each of these techniques exposed investors to the gains or losses on increased amounts of assets. If that's not leverage, what is? In fact, an article entitled "Harvard Endowment Chief Is Earning Degree in Crisis Management" in The New York Times of February 21 said of Harvard, "The endowment was squeezed partly because it had invested more than its assets "I find this statement quite remarkable, and yet no one has remarked on it to me.

It shouldn't be surprising that people engaging in these levered strategies made more than others when the market rose. But 2008 showed the flip side of that equation in action. In the future, investors should consider whether they really want to lever their capital or just invest the amount they have.

Sharing The Wealth

Apart from the increasing use of leverage, another trend that characterized the five years before the crisis was the widespread imposition of incentive fees.

In the 1960s, at the start of my chronology, only hedge funds commanded incentive fees, and there were too few for most people to know or care about. But fee arrangements that can be simplified as "two-and-twenty" flowered with private equity in the 1980s, distressed debt, opportunistic real estate and venture capital funds in the 1990s, and hedge funds in the 2000s. Soon they were everyplace.

Here are my basic thoughts on this sort of arrangement. (Oaktree receives incentive compensation on roughly half its assets; my objection isn't with regard to the fees themselves, but rather the way they've been applied.)

• It seems obvious that incentive fees should go only to managers with the skill needed to add enough to returns to more than offset the fees— other than through the mere assumption of incremental risk. For example, after a high yield bond manager's .50% fee, a 12% gross return becomes 11.5% net. A credit hedge fund charging a 2% management fee and 20% of the profits would have to earn a 16.375% gross return to net 11.5%. That's 36% more return. How many managers in a given asset class can generate this incremental 36% other than through an increase in risk? A few? Perhaps. The majority? Never.

• Thus, incentive fee arrangements should be exceptional, but they're not. These fees didn't go to just the proven managers (or the ones whose returns came from skill rather than beta); they went to everyone. If you raised your hand in 2003-07 and said
"I'm a hedge fund manager," you got a few billion to manage at two-and-twenty, even if you didn't have a record of successfully managing money over periods that included tough times.

• The run-of-the-mill manager's ease of obtaining incentive fees was enhanced each time a top manager capped a fund. As I wrote in "Safety First … But Where?" (April 2001),
"When the best are closed, the rest will get funded".

• In fact, whereas two-and-twenty was unheard-of in the old days, it became the norm in 2003-07. This enabled a handful of managers with truly outstanding records to demand profit shares ranging up to
50%.

• Clients erred in using the term
"alignment of interests" to describe the effect of incentive compensation on their relationships with managers. Allowing managers to share in the upside can bring forth best efforts, but it can also encourage risk bearing instead of risk consciousness. Most managers just don't have enough money to invest in their funds such that loss of it could fully balance their potential fees and upside participation. Instead of alignment, then, incentive compensation must be viewed largely as a "heads we win; tails you lose" arrangement. Clearly, it must be accorded only to the few managers who can be trusted with it.

• Finally, the responsibility for overpaying doesn't lie with the person who asks for excessive compensation, but rather with the one who pays it. How many potential LPs ever said,
"He may be a great manager, but he's not worth that fee". I think most applied little price discipline, as they were driven by the need to fill asset class allocations and/or the fear that if they said no, they might miss out on a good thing (more on this subject later).


I'm asked all the time nowadays what I expect to happen with investment manager compensation. First, I remind people that what should happen and what will happen are two different things. Then I make my main point: there should be much more differentiation. Whereas in past years everyone's fees were generous and pretty much the same, the post-2007 period is providing an acid test that will show who helped their clients and who didn't. Appropriate compensation adjustments should follow.

Managers who actually helped their clients before and during this difficult period— few in number, I think— will deserve to be very well compensated, and their services could be in strong demand. The rest should receive smaller fees or be denied incentive arrangements, and some might turn to other lines of work. Oaktree hopes to be among the former group. We'll see.

Ducking Responsibility

The inputs used by a business to make its products are its costs. The money it receives for its output are its revenues. The difference between revenues and costs are its profits. At the University of Chicago, I was taught that by maximizing profits— that is, maximizing the excess of output over input— a company maximizes its contribution to society. This is among the notions that have been dispelled, exposing the imperfections of the free-market system. (Hold on; I'm not saying it's a bad system, just not perfect.)

When profit maximization is exalted to excess, ethics and responsibility can go into decline, a phenomenon that played a substantial role in getting us where we are. The pursuit of short-term profit can lead to actions that are counterproductive for others, for society and for the long run. For example:

• A money manager's desire to add to assets under management, and thus profits, can lead him to take in all the money he can. But when asset prices and risks are high and prospective returns are low, this clearly isn't good for his clients.

• Selling financial products to anyone who'll buy them, as opposed to those for whom they're right, can put investors at unnecessary risk.

• And cajoling rating agencies into assigning the highest rating to debt backed by questionable collateral can put whole economies in jeopardy, as we've seen.


One of the concepts that governed my early years, but about which I've heard little in recent years, is "fiduciary duty." Fiduciary duty is the obligation to look out for the welfare of others, as opposed to maximizing for yourself. It can be driven by ethics or by fear of legal consequences; either way, it tends to cause caution to be emphasized.

When considering a course of action, we should ask, "Is it right?" Not necessarily the cleverest practice or the most profitable, but the right thing? The people I think of perverting the mortgage securitization process never wondered whether they were getting an appropriate rating, but whether it was the highest possible. Not whether they were doing the right thing for clients or society, but whether they were wringing maximum proceeds out of a pile of mortgage collateral and thus maximizing profits for their employers and bonuses for themselves.

A lot of misdeeds have been blamed on excessive emphasis on short-term results in setting compensation. The more compensation stresses the long run, the more it creates big-picture benefits. Long-term profits do more good— for companies, for business overall and for society— than does short-term self-interest.

Focusing On The Wrong Risk

The more I've thought about it over the last few months, the more I've concluded that investors face two main risks: (1) the risk of losing money and (2) the risk of missing opportunity. Investors can eliminate one or the other, but not both. More commonly, they must consider how to balance the two. How they do so will have a great impact on their results. This is the old dilemma— fear or greed?— that people talk about so much. It's part of the choice between offense and defense that I often stress (see, for example, "What's Your Game Plan?" September 2003).

The problem is that investors often fail to strike an appropriate balance between the two risks. In a pattern that exemplifies the swing of the pendulum from optimistic to pessimistic and back, investors regularly oscillate between extremes at which they consider one to the exclusion of the other, not a mixture of the two.

One of the ways I try to get a sense for what's going on is by imagining the conversations investors are having with each other … or with themselves. In 2003-07, with most investors worried only about achieving returns, I think the conversation went like this: "I'd better not make less than my peers. Am I behaving as aggressively as I should? Am I using as much leverage as my competitor? Have I shifted enough from stocks and bonds to alternatives, or am I being an old fogey? If my commitments to private equity are 140% of the amount I actually want to invest, is that enough, or should I do more?"

Few people seemed to worry about losses. Or if they were worried, they played anyway, fearing that if they didn't, they'd be left behind. That must be what drove Citigroup's Chuck Prince when he said, "as long as the music's playing, you've got to get up and dance. We're still dancing". The implication's clear: No worries; high prices. No risk aversion; no risk premiums. Certainly that describes the markets in 2003-07.

In the fourth quarter of 2008, when asset prices were collapsing, I imagined a very different conversation from that of 2003-07, with most investors saying, "I don't care if I never make another dollar in the market; I just don't want to lose any more. Get me out!" Attitudes toward the two risks were still unbalanced, but in the opposite direction.

Just as risk premiums disappear when risk is ignored, so can prospective returns soar when risk aversion is excessive. In late 2008, economic fundamentals were terrible; technical conditions consisted of forced selling and an absence of buyers; and market psychology melted down. Risk aversion predominated, and fear of missing out disappeared. These are the conditions under which assets are most likely to be available for purchase at prices way below their fair value. They're also the conditions in which most people go on buying strikes.

In the future, investors should do a better job of balancing the fear of losing money and the fear of missing out. My response is simple: Good luck with that.

Pursuing Maximization

When markets are rising and investors are obsessed with the fear of missing out, the desire is for maximum returns. Here's the inner conversation I imagine: "I need a return of 8% a year. But I'd rather have 10%. 14% would be great, and the possibility of 16% warrants adding to my risk. It's worth using leverage for a shot at 20%, and with twice as much leverage, I might get 24%."

In other words, more is better. And of course it is … except that to pursue higher returns, you have to give up something. That something is safety. But in hot times, no one worries about losing money, just missing out. So they try to maximize.

There should be a point at which investors say, "I need 8%, and it would be great if I could get 16%. But to try, I would have to do things that expose me to excessive loss. I'll settle for a safer 10% instead". I've labeled this concept "good-enough returns". It's based on the belief that the possibility of more isn't always better. There should be a point at which investors decline to take more risk in the pursuit of more return, because they're satisfied with the return they expect and would rather achieve that with high confidence than try for more at the risk of falling short (or losing money).

Most investors will probably say that in 2003-07, they didn't blindly pursue maximization; it was the other guys. But someone did it, and we're living with the consequences. I like it better when society balances risk and return rather than trying to maximize. Less gain, perhaps, but also less pain.

* * *

"Apropos of nothing," as my mother used to say, I'm going to use the opportunity provided by this memo to discuss market conditions and the outlook. On the plus side:

•  We've heard a lot recently about "green shoots": mostly cases where things have stopped getting worse or the rate of decline is slowing. A few areas have shown actual improvement, such as consumer confidence and durable goods orders. It's important when you consider these improvements, however, to bear in mind that when you get deep into a recession, the comparisons are against depressed periods, and thus easier.

•  It's heartening to see the capital markets open again, such that banks can recapitalize and borrowers can extend maturities and delever. Noteworthily, Michael Milken and Jonathan Simons wrote in The Wall Street Journal of June 20 that,
"Global corporations have raised nearly
$2 trillion in public and private markets this year …"

•  Investor opinion regarding markets and the government's actions has grown more positive, and as Bruce Karsh says,
"Armageddon is off the table". (He and I both felt 6-9 months ago that a financial system meltdown absolutely couldn't be ruled out.)

These positives are significant, but there also are many unresolved negatives:

•  Business is still terrible. Sales trends are poor. Where profits are up, it's often due to cost-cutting, not growth. (Remember, one man's economy measure is another's job loss— not always a plus for the overall picture.)

•  Unemployment is still rising, and with incomes shrinking, savings rising as a percentage of shrinking incomes, and credit scarcer, it's hard to see whose spending will power a recovery.

•  The outlook for residential and, particularly, commercial real estate remains poor, with implications for further write-offs on the part of the banks. Ditto for credit card receivables.

•  Many companies are likely to experience debt refinancing challenges, defaults, bankruptcies and restructurings.

•  Developments such as rising interest rates and rising oil prices have the power to impede a recovery.

•  Finally, no one can say with confidence what will be the big-picture ramifications of trillions of dollars of federal deficit spending, or the states' fiscal crises.


I'm not predicting that these things will turn out badly, merely citing potential negatives that may not be fully reflected in today's higher asset prices. My greatest concern surrounds the fact that we're in the middle of an unprecedented crisis, brought on by never-seen-before financial behavior, against which novel remedies are being attempted. And yet many people seem confident that a business-as-usual recovery lies ahead.

They're applying normal lag times and extrapolating normal decline/recovery relationships. The words of the late Amos Tversky aptly represent my view: "It's frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what's going on."

Peter Bernstein, a towering intellect who sadly passed away a month ago, made some important contributions to the way I think about investing. Perhaps foremost among them was his trenchant observation that. "Risk means more things can happen than will happen." Investors today may think they know what lies ahead, but they should at least acknowledge that risk is high, the range of possibilities is wider than it was ever thought to be, and there are a few that could be particularly unpleasant. Unlike 2003-07 when no one worried about risk, or late 2008 when few investors cared about opportunity, the two seem to be in better balance given the revival of risk taking this year. Thus the markets have recovered, with most of them up 30% or more from their bottoms (debt in December and stocks in March). [[But stocks are now so significantly higher— 65%, as opposed to the 30% or so when this was originally written— that we are once more in danger of overplaying our hand and largely ignoring risk.: normxxx]]

If you and I had spoken six months ago, we might have reflected on the significant stock market rallies that occurred during the decade-long Great Depression, including a 67% gain in the Dow in 1933. How uncalled-for those rallies appear in retrospect. But now we've had one of our own!

Clearly, improved psychology and risk tolerance have played a big part in the recent rally. These things have strengthened even as economic fundamentals haven't, and that could be worrisome. (On June 23, talking about general resilience— not investor attitudes— President Obama said the American people "…are still more optimistic than the facts alone would justify".) On the other hand, there's good reason to believe that at their lows, security prices had understated the merits. So are prices ahead of fundamentals today, or have they merely recovered from "too low" to "in balance"? There's no way to know for sure.

Unlike the fourth quarter of last year— when assets were depressed by terrible fundamentals, technicals and psychology— they're no longer at giveaway prices. Neither are they clearly overvalued. Maybe we should say "closer to fair". With price and value in reasonable balance, the course of security prices will largely be determined by future economic developments that defy prediction. Thus I find it hard to be highly opinionated at this juncture. Few things are compelling sells here, but I wouldn't be a pedal-to-the-metal buyer either. On balance, I think better buying opportunities lie ahead.


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