预测的价值，或这场雨从何而来？

Memo to: From:

Clients Howard Marks, TCW

Re: The Value of Predictions, or Where'd All This Rain Come From?

Anyone who has been my client for long has heard from me on many occasions with negative comments about market forecasts. Now, I have decided to say at once all of the bad things I can think of about predictions. The Expected Value of a Forecast = Value of Correct Forecast x Probability of Being Correct U

The motivation for trying to guess the direction of stocks or bonds is easy to understand. Observers have for years noted the wide price swings, calculated the value of a dollar invested at the bottoms and disinvested at the tops and compared the result against the value of a dollar invested under a “buy-and-hold” strategy. The difference is always temptingly large. P

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The problem, however, comes from the fact that none of the forecaster's attempts to capture the swings have any value unless his or her predictions are right. But It's Hard to be Right

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I agree with John Kenneth Galbraith. He said “We have two classes of forecasters: Those who don't know -- and those who don't know they don't know.” If it was easy to predict the future, it would be easier to attain excellent investment results -- then maybe everyone could have above-average performance. Being Right With Average Consistency Doesn't Help Let's face it: most of us have roughly the same ability to predict the future. And the trouble is that being right as often as the average forecaster won't produce superior results. U

Every investor wants results which are above average. In the institutional world, relative performance is the Holy Grail. Even elsewhere, the objective is to be the first to see the future -- and take the appropriate route to profit. It obviously doesn't help in these pursuits to be right only as often as others are.

1993 Oaktree Capital Management, L.P.

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An Average Forecast Doesn't Help Even If It's Correct

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Being "right" doesn't lead to superior performance if the consensus forecast is also right. For example, if the consensus forecast for real GNP growth is 5%, then stock prices will come to reflect that expectation. If you then conclude that GNP will grow at 5% and your expectation of rapid growth motivates you to buy stocks, the stocks you buy will be at prices which already anticipate such growth. If actual GNP growth at 5% is subsequently announced, stock prices probably will not jump -- because their reaction to 5% growth took place when the consensus forecast was arrived at. Instead, the best guess is that you will earn the normal risk-adjusted return for equities over your holding period. Bottom line: correct forecasts do not necessarily translate into superior investment results. Above-Average Profits Come From Correctly Forecasting Extreme Events

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At least twenty-five years ago, it was noted that stock price movements were highly correlated with changes in earnings. So people concluded that accurate forecasts of earnings were the key to making money in stocks. It has since been realized, however, that it's not earnings changes that cause stock price changes, but earnings changes which come as a surprise. Look in the newspaper. Some days, a company announces a doubling of earnings and its stock price jumps. Other earnings doublings don't even cause a ripple -- or they prompt a decline. The key question is not "What was the change?" but rather "Was it anticipated?" Was the change accurately predicted by the consensus and thus factored into the stock price? If so, the announcement should cause little reaction. If not, the announcement should cause the stock price to rise if the surprise is pleasant or fall if it is not. This raises an important Catch 22. Everyone's forecasts are, on average, consensus forecasts. If your prediction is consensus too, it won't produce above-average performance even if it’s right. Superior performance comes from accurate nonconsensus forecasts. But because most forecasters aren't terrible, the actual results fall near the consensus most of the time -- and non-consensus forecasts are usually wrong. The payoff table in terms of performance looks like this: U

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Forecast

Accurate?

Consensus

Non-Consensus

Yes

Average

Above Average

No

Average

Below Average

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The problem is that extraordinary performance comes only from correct nonconsensus forecasts, butnon-consensus forecasts are hard to make, hard to make correctly and hard to act on . U

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When interest rates stood at 8% in 1978, most people thought they'd stay there. The interest rate bears predicted 9%, and the bulls predicted 7%. Most of the time, rates would have been in that range, and no one would have made much money. The big profits went to those who predicted 15% long bond yields. But where were those people? Extreme predictions are rarely right, but they're the ones that make you big money. Most Forecasts are Extrapolations

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The fact is, most forecasters predict a future quite like the recent past. One reason is that things generally continue as they have been; major changes don't occur very often. Another is that most people don't do "zero-based" forecasting, but start with the current observation or normal range and then add or subtract a bit as they think is appropriate. Lastly, real "sea changes" are extremely difficult to foretell. That's why some of the best-remembered forecasts are the ones that extrapolated current conditions or trends but were wrong. Business Week may never live down "The Death of Equities" and "The Death of Bonds." At the mid-1990 lows, the press suggested that no one would ever buy a high yield bond again. In 1989, nobody thought the Cowboys would ever win without Tom Landry, or that the Lakers or 49ers would ever lose. Six years ago, the growth of both coasts' economies was considered assured, and the Rustbelt's suffering was expected to continue forever. Only two years ago, George Bush was a shoe-in. And that brings me to my subtitle: Where'd All This Rain Come From? The motivation for this memo came as I considered the extraordinary amount of precipitation the West has experienced this year -- and newspaper articles of a couple of months ago. According to the articles, the rings on old trees suggested that fifty year droughts might be the norm and the five year drought to date just the beginning. No one predicted the drought before it began -- when such a forecast might have helped. But just as it may have been about to end, the possibility of its long-term continuation was unveiled.

1993 Oaktree Capital Management, L.P.

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Forecasters are Usually Most Wrong at the Extremes

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It's at just such times --- such inflection points -- when accurate forecasts of change would be the most valuable but are the hardest to make. Take high yield bonds, for instance. In 1989 and 1990 they absorbed a continual beating as a series of negative developments came together. There was the recession, the failure of a number of the leveraged buyouts of the 1980s, enactment of excessively stringent regulation and the collapse of Drexel Burnham, Columbia Savings and Executive Life. All of this was tied together -- and accentuated -- by lots of overly negative publicity. Each development was another drip of "Chinese water torture." Each one put an end to some investor's ability to remain optimistic. And so each one eliminated a potential buyer, created a seller and moved prices lower. And after all, what is a market bottom? It's that moment when the last holder who will become a seller actually does so -- and thus the moment when prices hit levels that will prove to have been the lows. From that point on, with no one left to turn negative, a few pieces of good news or the arrival of a few buyers with belief in values are enough to turn a market. So you can see that the crescendo of negativism, the lowest prices and the greatest difficulty in predicting a rise all occur simultaneously. No wonder it's hard to profit from forecasting. Extreme Forecasts are Hard to Believe and Act On

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Let's say the average investor was approached in October 1990 by someone who had enough imagination and courage (because that's what was needed) to make a positive case for high yield bonds. Would the investor have believed and bought? Probably not. Potentially-profitable non-consensus forecasts are very hard to believe and act on for the simple reason that they are so far from conventional wisdom. If a forecast was totally logical and easily accepted, then it would be the consensus forecast (and its profit potential would be much less). So if someone told you the U.S. auto makers' share of domestic market was going back to 100% in five years, that would be a forecast with enormous implications for profit. But could you possibly believe it? Could you act on it? The more a prediction of the future differs from the present, (1) the more likely it is to diverge from the consensus forecast, (2) the greater the profit would be if it's right, and (3) the harder it will be to believe and act on it.

1993 Oaktree Capital Management, L.P.

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You Have to Be Right About Timing Too

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Not only must a profitable forecast have the event or direction right, but it must be correct as too timing as well. Let's say you accepted the forecast that the Big Three would come to again own 100% of the U.S. market, and you bought the stocks in response. What if a year later their share was lower (and their stocks too)? Could you continue to hold out for the long term, or would your resolve weaken? What if their shares (and stocks) were unchanged five years later? Wouldn't you give up? And wouldn't that be just in time to see the prediction come true? In poker, "scared money never wins." In investing, it's hard to hold fast to an improbable, non-consensus forecast and do the right thing…especially if the clock is telling you the forecast is off base. As I was told years ago, "being too far ahead of your time is indistinguishable from being wrong." Incorrect Forecasts Can Cost You Money

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As you know, we run our portfolios without reference to what we think the broad markets will do. An observer might think such behavior exposes us unduly to the fluctuations of the markets, and that to protect our clients we should actively go in and out of the markets based on what we think will happen. But remember, that will work only if our forecasts are right (and right more often than the consensus is right). I would argue that because forecasting is uncertain, it's safer not to try. For example, people hold equities because they find prospective long-term equity returns attractive. The average annual return on equities from 1926 to 1987 was 9.44%. But if you had gone to cash and missed the best 50 of those 744 months, you would have missed all of the return. This tells me that attempts at market timing are a source of risk, not protection. It would be nice in anticipation of subsequent performance to be able to vary the amount invested, but I think it's just too risky to try. It Costs Money to Make Forecasts

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As suggested above, the best thing might just be to settle for average long-term performance in markets that are hard to predict. Efficient marketeers think stock market forecasts are about as good as coin tosses. If you're right half the time without bias, your forecasts won't help or hurt versus buy-and-hold. But

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forecasts are implemented through transactions which cost money. If you're right half the time and spend money to try, your performance will fall further below buy-andhold results the more trading you do. Few People Revisit Their Forecasts

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We always read "I think the stock market's going to go up." We never read "I think the stock market's going to go up, (and 8 out of my last 30 predictions were right)" or "I think the stock market's going to go up (and by the way I said the same thing last year and was wrong)." Can you imagine deciding which baseball players to hire without knowing their batting averages? When did you ever see a market forecaster's track record? Most Forecasts Don't Allow for Alternative Outcomes

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I imagine that for most money managers, the process goes like this: "I predict the economy will do A. If A happens, interest rates should do B. With interest rates of B, the stock market should do C. Under that environment, the best performing sector should be D, and stock E should rise the most." The portfolio expected to do best under that scenario is then assembled. But how likely is E anyway? Remember that E is conditioned on A, B, C and D. Being right two-thirds of time would be a great accomplishment in the world of forecasting. But if each of the five predictions has a 67% chance of being right, then there is a 13% probability that all will be correct and the portfolio will perform as expected. And what if some other scenario unfolds? How will the portfolio do? How do the forecaster/investors make allowances in their portfolios for the likelihood that their predictions will prove incorrect? Lastly, Ask Yourself "Why Me?"

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By this I mean "if someone has made a potentially valuable forecast with a high probability of being right, why is it being shared with you?" Think how profitable a correct market forecast could be. With very little capital, a good forecaster could make many times more in the futures market than in salary from an employer. Okay, let's say he likes to work for other people -- than why does his employer give his forecasts away rather than sell them? Maybe the thing to ask yourself is whether you would write out a check to buy the forecast you're considering acting on.

1993 Oaktree Capital Management, L.P.

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Groucho Marx said "I wouldn't join any club that would have me as a member." Another formulation may be "I would never act on any forecast that someone would share with me." I'm not saying that no one has above-average forecasting ability. Rather, 'as one University of Chicago professor wrote in a paper years ago, such forecasters are more likely to be sunning themselves in Saint Tropez than going around entreating people to borrow their forecasts. *

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There is a bottom line for us on the subject of predictions regarding macro-scale events and widely-followed markets about which information is rather evenly disseminated (so-called efficient markets). In sum, we feel that: most forecasters have average ability consensus forecasts aren't helpful correct non-consensus forecasts are potentially very profitable but are also hard to make consistently and hard to bring yourself to act on forecasts cost money to implement and can be a source of risk rather than return The implications for us are clear. We will continue to eschew portfolio management based on forecasts of market trends, about which we think neither we nor anyone else knows much. Instead, we will continue to try to "know the knowable" -- that is, to work in markets which are the subject of biases, in which non-economic motivations hold sway, and in which it is possible to obtain an advantage through hard work and superior insight. We will work to know everything we can about a small number of things…rather than a little bit about everything. Convertible securities, high yield bonds and distressed company debt are all markets in which market inefficiencies give rise to unusual opportunities in terms of return and risk. We will continue to exploit these opportunities in a manner which is risk-averse and non-reliant on macro-forecasts. February 15, 1993 . . . [predictions] ought to serve but for winter talks by the fireside. Sir Francis Bacon

1993 Oaktree Capital Management, L.P.

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Random Thoughts on the Identification of Investment Opportunities Howard S. Marks -- January 24, 1994 U

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No group or sector in the investment world enjoys as its birthright the promise of consistent high returns. There is no asset class that will do well simply because of what it is. An example of this is real estate. People said, "You should buy real estate because it's a hedge against inflation," and "You should buy real estate because they're not making any more." But done at the wrong time, real estate investing didn't work.

2.

What matters most is not what you invest in, but when and at what price. There is no such thing as a good or bad investment idea per se. For example, the selection of good companies is certainly not enough to assure good results -- see Xerox, Avon, Merck and the rest of the "nifty fifty" in 1974. Any investment can be good or bad depending on when it's made and what price is paid. It's been said that "any bond can be triple-A at a price." There is no security that is so good that it can't be overpriced, or so bad that it can't be underpriced.

3.

The discipline which is most important in investing is not accounting or economics, but psychology. The key is who likes the investment now and who doesn't. Future prices changes will be determined by whether it comes to be liked by more people or fewer people in the future. Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge. The safest and most potentially profitable thing is to buy something when no one likes it. Given time its popularity, and thus its price, can only go one way: up. Watch which asset classes they're holding conferences for and how many people are attending. Sold-out conferences are a danger sign. You want to participate in auctions where there are only one or two buyers, not hundreds or thousands. You want to buy things either before they've been discovered or after there's been a shake-out.

4.

The bottom line is that it is best to act as a contrarian.

1994 Oaktree Capital Management, L.P.

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An investment that "everyone" knows to be undervalued is an oxymoron. If everyone knows it's undervalued, why haven't they bought it and driven up its price? And if they have bought, how can the price still be low? Yogi Berra said, "nobody goes to that restaurant; it's too popular." The equally oxy-moronic investment version is "Everybody likes that security because it's so cheap." 5.

Book the bet that no one else will. If everyone likes the favorite in a football game and wants to bet on it, the point spread will grow so wide that the team -- as good as it is -- is unlikely to be able to cover the spread. Take the other side of the bet -- on the underdog. Likewise, if everyone is too scared of junk bonds to buy them, it will become possible for you to buy them at a yield spread which not only overcompensates for the actual credit risk, but sets the stage for their being the best performing fixed income sector in the world. That was the case in late 1990. The bottom line is that one must try to be on the other side of the question from everyone else. If everyone likes it, sell; if no one likes it, buy.

6.

As Warren Buffet said, “the less care with which others conduct their affairs, the more care with which you should conduct yours." When others are afraid, you needn't be; when others are unafraid, you'd better be. It is usually said that the market runs on fear and greed. I feel at any given point in time it runs on fear or greed. U

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As 1991 began, everyone was petrified of high yield bonds. Only the very best bonds could be issued, and thus buyers at that time didn't have to do any credit analysis -- the market did it for them. Its collective fear caused high standards to be imposed. But when investors are unafraid, they'll buy anything. Thus the intelligent investor's workload is much increased. 7.

Gresham's Law says "bad money drives out good." When paper money appeared, gold disappeared. It works in investing too: bad investors drive out good. When undemanding investors appear, they'll buy anything. Underwriting standards fall, and it gets hard for demanding investors to find opportunities offering the return and risk balance they require, so they're forced to the sidelines. Demanding investors must be willing to be inactive at times.

1994 Oaktree Capital Management, L.P.

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Memo To:

Clients

From:

Howard S. Marks, TCW

Re:

Risk in Today's Markets

The ability of the stock market to react so harshly on February 4 to a small, Fedmandated rise in interest rates, pushing the Dow down 96 points, suggests a lack of preparedness for negative developments. This prompts me to write to you about certain risks I feel may be present in the markets today. There are plenty of bullish arguments to be made about the prospects for the economy and corporate profits, and pundits to make them. While I will not devote space or time to them, I don't pretend they are nonexistent. And I won't deny the possibility that as an inherently cautious investor, I sometimes tend to overstate the negatives. What I want to do, however, is point out the degree to which I feel investors are behaving in a risktolerant manner today, and the implications for all of us. Two very powerful trends are at work, and have been for the last few years. The first is the decline in interest rates, which has carried rates to the lowest levels of the last thirty years and brought on great dissatisfaction with the returns available from low-risk fixed income investments. The second is the fabulous performance which was produced by virtually all investments in securities from 1991 to 1993. This was a period in which risk-taking was rewarded, and almost without exception very high returns went to those who took great risk. Put these two phenomena together and what do you have? I think the answer is an environment in which risk-taking is greatly encouraged. It is often said that the market runs on fear and greed, but I believe it usually runs on fear or greed; that is, at most points in time, one or the other predominates. Right now, because of the two trends cited above, greed is greatly elevated and, perhaps more importantly, fear is in short supply. Thus, -

the money market investor, not content to earn 3% per year, (a negative return after taxes and inflation), turns to notes and bonds,

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the bond investor, unhappy with returns at the shorter (read "low-risk") end of the curve, extends maturities,

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the high grade bond investor drops down in quality,

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the fixed income investor turns to equities,

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the equity investor joins a hedge fund,

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-

the domestic investor looks overseas,

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the international investor emphasizes emerging markets, and

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the traditional bond-and-stock investor searches for "alternative investments" likely to repeat the success of the LBO and bankruptcy funds.

And why shouldn't they? The "stick" is the low prospective return offered in each investor's traditional bailiwick, and the "carrot" is the high returns earned recently in the riskier sectors. In brief, "why should I settle for 3% in T-bills when I can get double-digit returns in stocks?" There are numerous signs of infatuation with -- or non-questioning acceptance of -- the pursuit of high returns. The torrential inflow of dollars to mutual funds is one; I recently attended a conference at which a fund group representative said they were taking in $100 million a day, 90% of it for foreign funds. The rising level of margin debt is another. Books on investing are reaching the best-sellers list. The names of hedge fund managers are almost household words. And that brings me, for purposes of illustration, to the subject of hedge funds. When I first got to know the money management community twenty years ago, only a handful of managers were good enough to command a share of the profits as compensation. Today, according to a recent article in Forbes, there are 800 hedge funds, and some people think being accepted by one of the big names is the chance of a lifetime. I think it's important to remember, though, the symmetrical nature of most investments: almost every sword is two-edged, and he who lives by a risky strategy may die by it. Investments which will make you a great deal of money when things go well but not lose you a lot when things go poorly are very rare, and their existence must presuppose extremely inefficient markets. With the average stock or bond returning 10-15% last year, how did some hedge funds make 70% or more? It was through bold and heavilyleveraged plays on macro-developments such as currency movements. What would have happened if the managers' calculations had proved wrong? The hedge fund manager I know with the best performance last year, up more than 100%, is said twice in his life to have lost 30% in one day! Do the hedge fund aficionados know how much risk they are taking? For how long are they tying up their money? How much do they know about the strategies being employed? As the Forbes article pointed out, the sum of the "information" most hedge fund investors receive is a quarterly paragraph reporting the rate of return. I am not complaining about the fact that there are hedge funds, or about their popularity. My point is simply that the level of risk borne by investors is being systematically raised, often unknowingly and at a time when many valuations are quite high.

1994 Oaktree Capital Management, L.P.

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Comparison against low interest rates makes low earnings yields and dividend yields seem tolerable. Likewise, low rates increase the discounted present value of companies' future earnings as calculated by valuation models. For these reasons and others, many valuation indicators are at levels today which have proved dangerous and unsustainable in the past. Just as today's low interest rates are pushing investors toward riskier securities all along the "food chain" described above, however, this sword can also cut the other way. Warren Buffet said, in one of my favorite adages, "The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs." Another adage I'm fond of is, "What the wise man does in the beginning, the fool does in the end." No course of investment action is either wise or foolish in and of itself. It all depends on the point in time at which it is undertaken, the price that is paid, and how others are conducting themselves at that moment. When everyone shrinks from a security because it's "too risky," the few who will buy it can do so with confidence, secure in the knowledge that the price has not been bid up, and in the likelihood that others will eventually outgrow their fear and jump on the bandwagon. Today, many prices have been bid up, and the bandwagon is already crowded with wild-eyed investors. It is my view that, first, few of the trends being pursued are at their beginnings; money has been flowing to today's popular sectors for at least a year or two. Second, while some may argue that prices are not forbiddingly high, it's almost impossible to argue that they're very low (or that the easy money hasn't already been made). Third, it seems to me that investors are accepting higher levels of risk throughout the system. Here's one illustration: Our cautious high yield investing saved clients a lot of money and heartache in 1989 and 1990. Because we apply in-depth, downside-conscious credit analysis to the high yield segment of the bond market, and define it narrowly, investors who were chastened by the last decline and don't want to bear the full brunt of the next one have hired us repeatedly in the years since. Now, however, we detect increased interest in more "eclectic" managers who will buy cash-paying or non-cash-paying bonds, going concerns or bankruptcies, convertible or straight bonds, and U.S. or foreign debt. This is just one example, near to us, of the new acceptability of risk -- at what just might be the wrong time. Too-low interest rates and too-high prices may prove at some point to have set the stage for a correction. If so, many of the riskier tactics to which recent trends are pushing investors will increase the extent to which that correction is felt. What course of action, then, would we argue for? We do not preach risk-avoidance. In fact, the knowing acceptance of risk for profit is at the core of much of what we do, and we feel there is an important role today for investing which is creative and adaptable. But we would take this opportunity to exhort you to review most critically the risk associated with your current and contemplated

1994 Oaktree Capital Management, L.P.

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investments, and not to be among those who uncritically joined the trend toward risk. Whatever investment opportunities you decide on, we would encourage you to stress thorough appraisal of the risks entailed and cautious implementation. What is it that distinguishes the investment opportunities we’d suggest you pursue today? Not just the offer of high returns, but of returns which are more than proportionate to the risk entailed. The reason we champion inefficient markets (such as the high yield bonds, convertibles and distressed debt we're involved with) is that there exists by definition the potential, if exploited correctly, for an uncommonly favorable ratio of return to risk. Exploitation of opportunities in inefficient markets; insistence on preserving capital; refusal to pursue maximum return at the cost of maximum risk; specialization rather than dabbling; heavy emphasis on careful analysis; use of less-risky senior securities -- these themes have been the cornerstones of our approach over the years. They remain highly relevant and should continue to be pursued by all of us, especially at this point in the cycle.

February 17, 1994

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Memo To: From: Re:

Clients Howard S. Marks, TCW "Risk in Today's Markets" Revisited

Seven weeks ago, we put out a memorandum entitled "Risk in Today's Markets." Its essence was that the excellent returns earned in risky strategies through 1993 had eroded the fear factor in many markets and, coupled with the low yields available on conservative fixed income investments, had caused many investors to take "one giant step forward" on the risk curve. It also pointed out that just as declining rates had acted to raise prices and generate good returns, rate movements could cut the other way too. Lastly, it cautioned that when others are acting imprudently, driven by greed and without much fear, it is important that we raise our level of prudence. U

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Unfortunately, the events of the intervening seven weeks have shown these observations to be in order. It is the purpose of this follow-up memo to review the developments of the intervening time period, attempting to make sense out of what has happened and searching for lessons that can be drawn. It's about understanding basics of investing which don't come and go. The current "correction" dates from February 4, when the Federal Reserve Bank raised short term interest rates a small amount in order to choke off inflationary thought and action. The air quickly came out of the bond markets, and the decline has been swift and deep. Although there were good days for a while as well as bad, the bond market never did recover its equilibrium once the rate rise had begun. The yield on the 30-year Treasury bond rose from 6.21% on January 28 to 7.40% on April 4, with its price falling 14%, from 100.41 to 86.22. The decline spread quickly to other asset classes, and many investors in riskier strategies suffered harsh consequences. Some observers protest that economic and industry fundamentals continue to be favorable. But those positive developments had come to be valued too highly, and the resulting correction of valuations has been painful. It's important to note the first lesson, then: successful investing has at least as much to do with what you pay for an asset as it does with what that asset's fundamentals are . U

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But why did the Fed's half-point bump up in short rates cause such devastation? First, of course, even a small step in terms of policy-related tightening implies there may be much more to come. More importantly though, the move suddenly took a big bite out of investors' optimism and reawakened their fear. Through January, investors acted as if nothing could go wrong. That first rate rise served to remind them that something could go wrong -- and had. Thus there has been a swing back from a euphoric extreme. After the Fed's raising of rates opened their eyes to the negatives, investors also took notice of the tensions with Korea, Japan and China, the strength of the yen, and

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uncertainty over Whitewater. At the same time, Mexico's stock market had its own correction, in reaction to the assassination of the leading presidential candidate. The important lesson to be learned here is that whenever market participants act as if nothing can go wrong (or right), that represents an extreme swing of psychology -- of the pendulum we wrote about in April 1991 -- that must be recognized for what it is and acted on. As Roseanne Rozanadana used to say on Saturday Night Live, "it's always something." Investment actions predicated on everything continuing to go well are bound to fail . U

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If the spark that set off the decline in bond prices was the rate increase, why did the slump spread to so many other markets, including equities, foreign bonds, and commodities? Where were the benefits of strategic diversification? I would respond citing the following factors: -

First, interest rates affect the value of everything. Investing consists of putting out money today in order to get more back at a later date. The "discounted present value" of the projected future proceeds varies inversely with the current level of interest rates. Simply put, when rates rise, the present value of a future dollar declines.

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Another reason the impact of rates is broad stems from the fact that, as I was once told by sid Cottle (of Graham, Dodd and Cottle fame), "Investing is the discipline of relative selection." That is, the attractiveness of x is in part a function of the price of y. If bonds cheapen and thus come to promise higher prospective returns, stocks (or any other asset) will appear relatively less attractive at their old prices and thus must cheapen as well in order for their prospective returns to regain competitiveness versus those of bonds.

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Further, it used to be, for example, that Americans determined the prices of U.S. stocks based on U.S. economic developments and Europeans determined the prices of European stocks based on European developments. These were local markets then, and they behaved differently. Today, investing is more globalized, and the prices of assets in different countries are determined by many of the same people, who may respond in common to fundamentals and psychology.

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The last reason many assets have moved together is that in this particular episode, many hedge funds managers (who, as we will discuss later, appear to have had a disproportionate impact on recent events) were forced by their increased capital to invest aggressively in macro-trends spanning national borders. This small group of hyper-active investors may have hooked markets up to an unusual degree.

For these reasons and others, asset prices may prove more highly interconnected than one had expected.

1994 Oaktree Capital Management, L.P.

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The most noteworthy feature of the recent correction may be the role of some prominent hedge fund managers. It was reported on February 25 that George Soros's Quantum Fund had lost $600 million on its yen position in one day. On April 1, we read that Michael Steinhardt had lost $1 billion of his $5 billion under management, due largely to the drop in bond prices, and that in the last two months, investors in Askin Capital Management's Granite Funds may have lost 100% of their $600 million capital in mortgage backed securities. Hedge funds occupied a meaningful part of our February 17 memo because they were felt to exemplify (to a power of ten) the risk-tolerant behavior of investors in general. Thus their subsequent experience can offer us some valuable and highly magnified insights. The important observations, applicable to all investment behavior, are as follows: -

Words alone mean very little. Just as "portfolio insurance" turned out in the 1987 Crash not to insure much, today's startling losses indicate that many "hedge funds" don't really hedge enough to make a difference, and that the Granite Fund, which described itself as "market neutral," was anything but.

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Following from the above, we are reinforced in the belief that some investors don't know what their managers are doing, or how much risk they're taking. As one "fund of funds" which had invested in the Granite Fund told the Wall Street Journal, "It's unbelievable. This was touted as a low-risk, lowvolatility, market-neutral investment. We were clearly misled." Only by really knowing what a manager does can you be sure he is right for you, but this often comes down to whether the manager truly understands his market, describes it accurately and does what he says he will -- things that can't be assessed from a marketing brochure.

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Investment strategy really is a two-edged sword, and he who lives by an aggressive strategy usually can die by it. It proved possible for investors to become too comfortable with volatility -- when it was on the upside and called "profit." Volatility is a lot less enjoyable when it turns to the downside, but it's the flip side of the same coin.

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The outcome can actually be worse than symmetrical when incentive fees are involved, as Jan Greer of William Simon & Sons points out. That's because while hedge fund managers took 20% of last year's big profits, they won't replace a like percentage of subsequent losses. Usually, due to the peculiarities of the math, if a portfolio is up 50% one year and down 33% the next, it's back to where it started. But if the manager takes a fifth of the 50% gain in year 1, a 33% decline in year 2 will leave it 7% under water.

1994 Oaktree Capital Management, L.P.

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As an experienced corporate director told Forbes a few years ago, "I no longer expect people to do what I tell them to do; I've learned they only do what I pay them to do." But while a hedge fund manager may have his reputation and some capital at stake, as to fees he is in a heads-we-win-tails-you-lose position. For a manager who is paid a percentage of the profits on a one-yearat-a-time basis, a single year of investing aggressively enough at the right time can make him rich for life. Thus managers should be entrusted with incentive fee arrangements only if they can truly be counted on to add significant value which is not accompanied by proportionate risk. U

U

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Volatility + leverage = dynamite. Only now do we see articles pointing out (after the fact) that if a hedge fund borrows short to buy long Treasury bonds with 6% "down," a 1% rise in the bonds' yield will wipe out 100% of the equity in the position.

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When volatile securities have been bought on margin, sale may be forced if the investor can't come up with more capital during a decline. This is a big part of what put the Granite Fund under. If you own securities without borrowing, you may experience a price drop -- which will hopefully prove temporary -- but you can't be put out of the game.

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One characteristic of many inefficient markets is some measure of illiquidity. Thus when sales are forced in a chaotic market -- whether by margin calls, client withdrawals or cold feet -- they can have the effect of contributing to or exacerbating the decline. Often in this environment, the manager's choices for liquidation will be limited to his highest quality and most marketable holdings. In this way, forced sales can easily contribute to a deterioration of portfolio quality. When the Granite Fund received margin calls, its manager could only get reasonable bids for securities which perform well when rates rise. Selling them cost the fund its hedge.

The prominent hedge funds that attracted the recent attention -- favorable in 1993 and less so this year -- are multi-billion-dollar entities which, because of their size, often invest not in the undervalued micro-situations on which their early records were built, but in macro-phenomena all around the world. Thus they provide an important object lesson to which we want to point. These funds are run by managers who pursue aggressive returns through the use of highly leveraged and thus volatile positions in large markets, some of which, such as Treasury bonds, are relatively efficient. In this sense, they represent the opposite of what we espouse. Our approach emphasizes the low-risk exploitation of inefficient markets, as opposed to aggressive investment in efficient ones. We restrict ourselves to markets where it is possible to know more than other investors. We put avoiding losses ahead of the pursuit of profits. And we do not seek to employ leverage.

1994 Oaktree Capital Management, L.P.

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Inefficient markets must by definition entail illiquidity and occasional volatility, but we feel unleveraged and expert investment in them offers investors with staying power the best route to high returns without commensurately high risk. And we also feel investors who are capable of observing clinically can learn some valuable lessons from the current episode. We look forward to learning along with you.

April 11, 1994

1994 Oaktree Capital Management, L.P.

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To:

Clients

From:

Howard Marks

Date:

July 15, 1994

Subject:

"How Does an Inefficient Market Get That Way?"

In an efficient market, the actions of intelligent, informed, diligent and objective investors cause assets to be priced fairly based on the available information such that their prospective returns are in proportion to their risk. No bargains are available, and the only way to increase expected return is to take on more risk. But in an inefficient market, this process breaks down. The prerequisites for efficiency are not fully satisfied, and thus prices are able to diverge from what they "should" be. Some assets become overpriced and others underpriced. Profits can be earned by applying skill, not just for bearing risk. It becomes possible to consistently achieve superior risk-adjusted returns. But how does a market get that way? There are many possible reasons. Maybe most investors ignore the market niche because it is little known. Perhaps information is skimpy or unevenly disseminated. Market infrastructure may be under-developed, so trading difficulties scare investors away. Maybe there's no trade reporting, so Seller A doesn't know what B got just a few minutes earlier and settles for less. The list of possible reasons goes on and on, but we have our own favorite: Investors fail to act objectively and dispassionately. An efficient market must be unbiased. That is, the participants must be motivated just by economics and willing to either buy or sell depending on price. If every owner wants to (or must) sell a given good and won't become a buyer no matter how low the price goes, the price of that good can fall below the "fair" level and it will become possible to find bargains. Conversely, prices can go too high when everyone wants to own something . . . whether it's tulip bulbs, South Sea pearls or nifty-fifty stocks. And that brings us to the high yield bond market which remains, in our opinion, decidedly inefficient. High yield bonds continue to offer 350-400 basis points more yield than "riskless" Treasury bonds to compensate for the risk of losing 50-150 basis points per year to credit problems. And high yield bonds have the best performance record of any major sector of the fixed income universe for virtually every period through today. One would certainly expect these facts to attract buyers and raise prices. In 1984, I was sure this market would become efficient in five years. But it hasn't done so ten years later, despite the high historic and prospective returns. Why haven't enough buyers stepped forward to eliminate the excessive risk premium, render these bonds fairly priced and correct the inefficiency?

1994 Oaktree Capital Management, L.P.

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The answer, we feel, is simple: investors continue to be unfairly prejudiced against them. Not every investor, clearly, but enough big players to create a buyers' market and tilt the opportunity in favor of those who are willing to participate. Prove it, you say? Well, this memo was occasioned by an article in "Pensions & Investments" reporting consultant SEI's recommendation that pension plan sponsors invest 10% to 30% of their fixed income portfolios in high yield bonds. As I went through the article, my reaction was that it was a great selling piece for our market sector -- not just SEI's recommendation, but what the article demonstrated about investor attitudes. According to the article, SEI feels "a sponsor could add about 20 basis points of return without adding risk by putting 10% of its fixed income portfolio in high yield, or junk, bonds." And that's after SEI "tried to be as conservative as possible in its assumptions." I'm sold! But the article goes on to show how a market can be biased against an asset class: . . . High yield is perceived as a way to add diversification, but is not wellreceived by clients. "Not a lot of our clients are opting to use them . . . . We work with some clients who just plain don't want them in their portfolio." (Callan) Because of the negative publicity surrounding high yield bonds around the turn of the decade, plan sponsors either are wary of investing in them, or are afraid of being associated with them. (Pensions & Investments) Some plan sponsors may be limited by plan guidelines to investment-grade securities, . . . Other sponsors may be wary of junk bonds because of the market's well-publicized collapse in 1989 and 1990, and the securities' association with Michael Milken and the now-defunct bond house Drexel Burnham Lambert. (SEI) If we're going to worry about a collapse, I hope it'll be one looming ahead, not one which occurred five years ago. The asset class that collapsed in the past is likely to be cheap, not to be riding a crest of popularity and thus heading for a fall. But too many investors drive looking in the rear-view mirror. As someone at my former place of employment once told clients, "We're buying the oils; they've been good to us." We'd rather buy what has performed badly or is the subject of negative bias and thus is cheap. We feel strongly that high yield bonds qualify today, and we'd be glad to talk more about them, or about the opportunities in other areas.

1994 Oaktree Capital Management, L.P.

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