Analysis of the latest memo from value investing guru Howard Marks: Thoughts on asset allocation

Oaktree Capital Management is one of the world's largest distressed debt investors, and its founder, Howard Marks, is widely known as a guru of value investing. His works "The Most Important Thing" and "Mastering the Market Cycle" are considered investment bibles by readers around the globe. Recently, Howard Marks released his latest investment memo, dedicating a significant amount of space to discussing asset allocation and debt. This article will focus on Oaktree Capital's perception of the yield curve and its impact on the cryptocurrency market. It is recommended to read the previous article first to understand Howard Marks' fundamental views on ownership and debt.

Review of the previous article: Analyzing the latest memo from value investing guru Howard Marks: Thoughts on asset allocation

In an Efficient Market, Beta is More Important

All our discussions revolve around the assumption of an efficient market. Howard Marks made three statements regarding efficient markets:

• As risk increases in an efficient market, expected returns also increase proportionally. To put it the other way around: as expected returns increase, the uncertainty and possibility of worse outcomes associated with risk also increase. Therefore, no point on the curve is "better" than any other. It is simply a matter of how much absolute risk you are willing to take or what level of absolute return you seek. The risk-return ratios of all points are essentially the same; the lower the return on the left, the higher the return on the right.
• Furthermore, from every position on the curve, the symmetry of the vertical distribution around expected returns from one position to the next is similar. This means that there is no clear advantage of the upside potential versus downside risk ratio at any given position on the curve compared to others.
• Lastly, to further reduce risk, one can consider investing in riskier assets or using the original strategy but with added leverage to amplify expected returns and risks. Similarly, in an efficient market, neither of these strategies is inherently superior to the other.

These three statements reflect some important implications of the assumed market efficiency. From this perspective, the most important thing is to find the risk position that suits you. This is because from an academic perspective, in an efficient market:

a) the pricing of all assets is relatively fair, so there are no exploitable situations of bargaining or overpricing

b) there is no such thing as alpha, which Howard Marks defines as "the benefit gained from superior individual skill." Therefore, active investing does not bring any advantage, as no asset class, strategy, security, or manager is superior to any other in terms of risk and the returns generated with that risk.

Similarly, from an academic perspective, since there is no alpha, the only thing that distinguishes assets is their beta value, or their relative volatility, i.e., the degree to which they reflect market changes. In theory, expected returns are directly proportional to beta.

There is No Alpha in this Market

Howard Marks points out that from an academic standpoint, the market is not perfectly efficient. The market can efficiently accomplish the following:

a) Quickly integrate new information

b) Accurately reflect the consensus opinion on the correct price for each asset given all available information, but this opinion may be biased. Therefore, gains can be made by cleverly choosing among the following options:

- Certain assets, markets, or strategies may offer better risk/reward trades than others

- Some managers may operate within a market or strategy to generate superior risk-adjusted returns.

The latter idea raises a key question in asset allocation: should one consider deviating from the optimal point of risk level, i.e., deviating from the original risk-return curve, to invest in riskier asset classes alongside investment managers believed to possess alpha? This question does not have a simple answer, and even those investment managers believed to possess alpha may not have the answer.

Most People Misjudge the Relationship between Risk and Return; Reading This Might Change Your Strategy

Howard Marks emphasizes that every investor should consider their investment horizon, financial situation, income, needs, desires, responsibilities, and tolerance for fluctuations to set a baseline for risk tolerance. This is fundamental, and then they can stick to this strategy or choose to occasionally deviate from it to adapt to market changes. In times of market downturn, opting for a more active investment strategy, and when the market is up, focusing more on capital preservation.

In 2017, dubbed a Ponzi scheme, Howard Marks' latest memo: Thanking my son for holding a substantial amount of Bitcoin.

Howard Marks then addresses the age-old question of the change in the risk-return curve. As we all know, moving from left to right, as expected risk increases, expected return also increases.

However, he disagrees with the traditional risk-return curve, finding it inadequate as the linear representation makes the relationship between risk and return seem too certain. This masks the nature of risk. Therefore, in a 2006 memo, Howard Marks overlaid a bell-shaped curve representing probability distribution on the same line to show the uncertainty of risk asset returns.

He then places several asset allocation ratios into this return curve:

• Blue curve: 2/3 debt and 1/3 equity
• Red curve: 1/3 debt and 2/3 equity

As expected returns increase, expected risks also increase, meaning the range of possible outcomes widens. Howard Marks believes this presentation of options may be more intuitive and clear. He points out that those who believe in the traditional risk-return curve, "the higher the risk, the higher the return," and adopt high-risk strategies. Upon understanding the real impact of increased risk through the adjusted risk-return curve, they may opt for a more moderate strategy.

Has Your Annual Return Surpassed 7%? If Not, Why Not Embrace Bonds?

At the end of the article, Howard Marks revisits the key points:

• Essentially, the only asset classes are equity and debt, which have significant differences in nature.
• Combining equity and debt assets to position one's investment portfolio appropriately is the most crucial decision in portfolio management or asset allocation. Other decisions are merely execution issues.
• Asset allocation depends on how one evaluates their strategy and the ability to access superior managers.

Howard Marks then discusses the reasons for investing in debt at Oaktree Capital, as previously mentioned, due to the changes in interest rates, the expected returns in the debt market have been steadily increasing post-2021. Tether has also benefited from these rising profits, hitting new highs. However, with the US heading towards rate cuts, the subsequent developments are worth monitoring if not raided by the US. Additionally, it is observed that in the Real World Asset (RWA) market, the most significant commodity is tokenized government bonds. The views of such a prominent investor as Howard Marks might ignite a frenzy around government bonds.