Analysis of Value Investing Guru Howard Marks Latest Memo Reflections on Asset Allocation Part 2

Oaktree Capital Management is one of the world’s largest distressed debt investors, and its founder Howard Marks is also known as a value investing guru. His works “The Most Important Thing” and “Mastering the Market Cycle” are widely regarded as investment bibles by readers worldwide. Recently, Howard Marks published a new investment memo, dedicating a lot of space to discussing asset allocation and debt. This article will focus on Oaktree Capital’s understanding of the yield curve and its impact on the cryptocurrency market. It is recommended to read the previous article to understand Howard Marks’ fundamental views on ownership and debt.

In an efficient market, beta is more important

All discussions conducted revolve around the assumption of an efficient market, and Howard Marks provides three statements about an efficient market:

– With an increase in risk in an efficient market, expected returns will also increase proportionally. Conversely, it might be better to say: as expected returns increase, the associated risk (uncertainty of outcomes and worse possibilities) also increases. Therefore, no position on the curve is “better” than any other position. It’s just a matter of how much absolute risk you want to take or what level of absolute return you want to achieve. The risk-return ratios of all points are essentially the same, with lower returns on the left and higher returns on the right.
– Additionally, from every position on the curve, the symmetry of the vertical distribution around expected returns is similar from one position to the next. This means that the ratio of upside potential to downside risk at a particular position on the curve is not significantly better than at any other position.
– Finally, if you want to further reduce risk, you can consider either (a) investing in riskier assets or (b) using the same strategy but adding leverage attributes (amplifying expected returns and risks) to achieve this. Similarly, in an efficient market, neither of these strategies is superior to the other.

These three statements reflect some important implications of the assumed market efficiency, where the only thing that matters is finding the right risk position for oneself. This is because, from an academic perspective, in an efficient market:
– All assets are priced relatively fairly, so there are no opportunities for bargaining or overpricing.
– There is no such thing as alpha, defined by Howard Marks as “the benefit gained from superior individual skills.” Therefore, active investing does not bring any benefits, and no asset class, strategy, security, or manager is better than any other in terms of risk and the return generated as a result of risk.

Similarly, from an academic perspective, since there is no such thing as alpha, the only thing that distinguishes assets is their beta value, or their relative volatility, reflecting the extent to which they respond to market changes. Theoretically, expected returns are directly proportional to beta.

This market has no alpha

Howard Marks points out that, from an academic perspective, the market is not perfectly efficient. The market can efficiently perform the following functions:
– Quickly integrating new information.
– Accurately reflecting the consensus opinion on the correct price of each asset given all available information, but this opinion may be biased. Therefore, there may be opportunities to generate returns by cleverly choosing certain assets, markets, or strategies:
– Some assets, markets, or strategies may offer better risk/return trades than others.
– Some managers may operate within a market or strategy to produce superior risk-adjusted returns.

The latter idea raises a key question in asset allocation: should one consider deviating from the optimal risk level (i.e., deviating from the original risk-return curve) to invest in asset classes with higher risk and potential alpha from investment managers? This question does not have a simple answer, as investment managers believed to have alpha may not have one.

Most people misjudge the relationship between risk and return, and reading this article may change your strategy

Howard Marks points out that every investor should consider their investment horizon, financial situation, income, needs, desires, responsibilities, and ability to withstand fluctuations to set a bottom line 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, opt for a more proactive investment strategy, while in times of market upturn, focus more on preserving capital.

Howard Marks then discusses the ancient question: the changing risk-return curve. As we all know, moving from left to right, expected risk increases, and expected return also increases.


Source: Oaktree Capital

But he disagrees with the traditional risk-return curve, finding it inadequate because the linear representation makes the relationship between risk and return appear overly certain. This obscures the nature of risk, so in a 2006 memo, Howard Marks added some bell-shaped curves representing probability distributions on the same line to show the uncertainty of risk asset returns.


Source: Oaktree Capital

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


Source: Oaktree Capital

As expected returns increase, expected risk also increases (meaning the range of possible outcomes widens). Howard Marks believes that presenting options in this way may be more intuitive and clear. He points out that if one believes in the traditional risk-return curve, “the greater the risk, the greater the return,” and adopts a high-risk strategy, they may choose a more moderate strategy after understanding the real impact of increased risk (the adjusted risk-return curve).

Has your annualized return exceeded 7%? If not, why not embrace bonds

At the end of the article, Howard Marks reviews the key points once again:

– Fundamentally, the only asset classes are equity and debt, and they differ significantly 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, with other decisions being merely execution issues.
– Asset allocation depends on how one evaluates their strategy and the ability to access skilled managers.

Howard Marks then talks about the reasons for Oaktree Capital’s investment in debt, as previously mentioned, benefiting from changes in interest rates, the expected returns in the debt market after 2021 are steadily increasing. Tether is also benefiting from this, continuously setting new highs in returns, but following the US’s move towards interest rate cuts, further developments are worth monitoring (if not disrupted by US regulatory actions). At the same time, it is noted that in the Real World Asset (RWA) market, the largest commodity is still tokenized national debt. Whether the views of such a renowned investor as Howard Marks will spark a frenzy around national debt remains to be seen.