Howard Marks, CFA, is co-chairman of Oaktree Capital, where he contributes his experience to big-picture decisions relating to investments and corporate direction. He shared his insights on investing and managing the business cycle for the CFA Society Chicago community on February 22, 2019. His presentation, entitled “Investing in a Low-Return World,” touched on some of the big questions investors are asking themselves today: Should we lower our return expectations? And if so, how do we make money in a low-return world?
Marks describes today’s environment as a “low-return, high-risk world.” Prospective returns and safety are hard to come by in the current over-optimistic climate where people have great trust in the future. Combined with higher risk-aversion, such sentiments lead to asset price appreciation, which means lower future returns, without any lower risk.
Let us follow Marks back to basics to consider what lower returns actually mean. Consider the CAPM model, which shows the trade-off between risk and return. As central banks have lowered interest rate, this line has shifted down. For the same level of risk, you now have lower returns, whether you are investing in T-bills or equity. The CAPM model hints at two reasons why taking more risk is no surefire way to higher returns. For one, the downward shift in the CAPM-line means that returns are lower even for such risky ventures like private equity. Secondly, and more fundamentally, the CAPM does not ensure higher return for riskier assets. As Marks explains, if higher returns were guaranteed for these assets, they would not be risky. For risky assets, therefore, while required returns appear to be higher, there is a wide range of possible outcomes that offer no safe way to high returns.
In Marks’ view, the seven worst words are ”too much money chasing too few deals.” This is what we are seeing today, with returns lower across the board. As Marks clarifies in a memo, “too much money” does not mean investors have more money on their hands to invest, but that they are moving resources out of cash, where returns are low, to seek more risky opportunities, and as such, push down required returns on riskier investments.
What, then, is an asset manager to do in this environment? You cannot both position yourself correctly in a heated bull market and be positioned for reversal at the same time. Counting on historical returns being the same in the future is foolish but settling for today’s low returns contradicts the business plan of most organizations. You may not survive in the business if you go all into cash and wait for a better environment.
As an asset manager, argues Marks, you have two jobs, that of asset selection and cycle positioning. You cannot give up on timing when to be aggressive because then you cannot ever be defensive. Cycle positioning does not mean forecasting economic growth for the next year. Marks makes very clear that he does not believe in forecasting. Instead, you need to understand where you are in the relevant cycles, such as the business cycle, credit cycle, and the market psychology cycle. Knowing where you are gets the odds on your side. It does not mean you can predict what will happen tomorrow but it should tell you whether to be more aggressive or more cautious. Marks explains that there are times for aggressiveness and times for caution:
- When prices are low, pessimism is widespread and investors flee from risk, it is time to be aggressive.
- When valuations are high, enthusiasm is rampant and investors are risk-tolerant, it is time for caution.
It seems Oaktree’s view is that the current environment is a mixed bag. For the past three years, their mantra has been “move forward but with caution.” This, as Marks explains, means being fully invested while biasing the portfolio towards defense rather than offence.
In addition to getting the cycles on your side, explains Marks, there are opportunities for alpha also in the current environment. Despite low returns overall, there are mispricings to exploit. You do have more and less efficient markets, and with the right set of skills, you can identify them. This is harder than it used to be, when there were more structural and persistent inefficiencies to exploit. Nowadays, most inefficiencies are cyclical, and emerge only once in a while.
In inefficient markets, some investors will earn positive alpha, and some negative alpha, so you should enter these markets only if you think you can be on the right side of the trades. You can do this only if you dare to be a contrarian. Going this rout is risky and costly but it is the right way to invest if you have the skills to do it.