Howard Marks on Compounding

I’ve written so much about this that I’m not going to belabor it further (see my memo Ruminating on Asset Allocation, October 2024), but I’m always available to talk. (Before the bond pros jump down my throat, I’ll admit that the foregoing is less than 100% accurate. There are three components in bond returns, not two. Everyone knows about the interest payments and the movement of price to par at maturity. But there’s a third: the interest earned from reinvesting the annual interest payments, better known as “interest on interest,” and thanks to the power of long-term compounding, this is a major matter on 20- or 30-year bonds. The standard yield-to-maturity calculation assumes interest receipts are reinvested at the yield in effect at time the calculation is performed (for example, at purchase), but that’s a simplifying assumption, and the reality may well be different. No one wants to see the price of a bond one owns decline. But the truth is that if the bond price declines, the yield rises, meaning interest payments received can be reinvested at a higher rate than was anticipated. Thus, surprisingly, interim price declines can raise the overall return earned from holding a bond to maturity.) What About Private Credit? This is today’s other FAQ, along with the one about spreads. A lot of people have questions about private credit, which makes one wonder how the sector can be seeing such strong capital inflows.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: (Yet Again), the U.S. is able to do this because to date the world has given it virtually unlimited credit at particularly low interest rates. The result has been fiscal deficits in 41 of the last 45 years and trillion- dollar-plus deficits in all of the last five. If your brother-in-law behaved this way, you’d call him irresponsible. Economist John Maynard Keynes said in the 1930s that if an economy is growing too slowly to produce the needed jobs, the government should engage in deficit spending. By doing so – putting more into the economy through spending than it takes out in taxes – it stimulates economic growth and thus job creation. And then, when prosperity is restored, the government should run a surplus – spending less than it takes in – and pay down the debt. Today, U.S. politicians from both parties are in the habit of spending without regard to the deficit, and the part about surpluses and paydowns has been forgotten. In fiscal year 2024, for example, the U.S. ran a deficit of roughly $1.8 trillion, or 6.4% of GDP, in a time of prosperity. If we continue to borrow and add to the national debt every year at a rate that exceeds the growth of GDP, the interest bill at a constant interest rate will take up a bigger and bigger percentage of the budget, adding to future deficits and debt. The interest bill will compound as a percentage of GDP, and so will the debt.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: investors are able to ignore short-term performance, hold for the long run, and avoid excessive trading costs, while everyone else worries about what’s going to happen in the next month or quarter and therefore trades excessively. In addition, long-term investors can take advantage if illiquid assets become available for purchase at bargain prices. Like so many things in investing, however, just holding is easier said than done. Too many people equate activity with adding value. Here’s how I summed up this idea in Liquidity, inspired by something Andrew had said: When you find an investment with the potential to compound over a long period, one of the hardest things is to be patient and maintain your position as long as doing so is warranted based on the prospective return and risk. Investors can easily be moved to sell by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of a new, seemingly more promising idea. When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell. Everyone wishes they’d bought Amazon at $5 on the first day of 1998, since it’s now up 660x at $3,304. • But who would have continued to hold when the stock hit $85 in 1999 – up 17x in less than two years?

The long-term decline in interest rates began just a few years after the advent of risk/return thinking, and I view the combination of the two as having given rise to (a) the rebirth of optimism among investors, (b) the pursuit of profit through aggressive investment vehicles, and (c) an incredible four decades for the stock market. The S&P 500 Index rose from a low of 102 in August 1982 to 4,796 at the beginning of 2022, for a compound annual return of 10.3% per year. What a period! There can be no greater financial and investment career luck than to have participated in it. An Incredible Tailwind What are the factors that gave rise to investors’ success over the last 40 years? We saw major contributions from (a) the economic growth and preeminence of the U.S.; (b) the incredible performance of our greatest companies; (c) gains in technology, productivity and management techniques; and (d) the benefits of globalization. However, I’d be surprised if 40 years of declining interest rates didn’t play the greatest role of all. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

In fact, just as continued buying of appreciated assets can eventually turn a bull market into a bubble, widespread selling of things that are down has the potential to turn market declines into crashes. Bubbles and crashes do occur, proving that investors contribute to excesses in both directions. In a movie that plays in my head, the typical investor buys something at $100. If it goes to $120, he says, “I think I’m onto something – I should add,” and if it reaches $150, he says, “Now I’m highly confident – I’m going to double up.” On the other hand, if it falls to $90, he says, “I’m going to think about increasing my position to reduce my average cost,” but at $75, he concludes he should reconfirm his thesis before averaging down further. At $50, he says, “I’d better wait for the dust to settle before buying more.” And at $20 he says, “It feels like it’s going to zero; get me out!” Just like those who are afraid of surrendering gains, many investors worry about letting losses compound. They might fear their clients will say (or they’ll say to themselves), “What kind of a lame- brain continues to hold a security after it’s gone from $100 to $50? Everyone knows a decline like that can foreshadow further declines. And look – it happened.” Do investors really make behavioral errors such as those I’ve described? There’s plenty of anecdotal evidence. For example, studies have shown that the average mutual fund investor performs worse than the average mutual fund.

• Strong economic growth and lower interest costs added to corporate profits. • Valuation parameters rose, as described above, lifting asset prices. Stocks increased non-stop for more than ten years, except for a handful of downdrafts that each lasted a few months. From a low of 667 in March 2009, the S&P 500 reached a high of 3,386 in February 2020, for a compound return of 16% per year. • The markets’ strength encouraged investors to drop their crisis-inspired risk aversion and return to risk taking much sooner than expected. It also made FOMO – the fear of missing out – the prevalent emotion among investors. Buyers were eager to buy, and holders weren’t motivated to sell. • Investors’ revived desire to buy caused the capital markets to reopen, making it cheap and easy for companies to obtain financing. Lenders’ eagerness to put money to work enabled borrowers to pay low interest rates under less-restrictive documentation that reduced lender protections. • The paltry yields on safe investments drove investors to buy riskier assets. • Thanks to economic growth and plentiful liquidity, there were few defaults and bankruptcies. • The main exogenous influences were increasing globalization and the limited extent of armed conflict around the world. Both influences were clearly salutary. As a result, in this period, the U.S. enjoyed its longest economic recovery in history (albeit also one of its slowest) and its longest bull market, exceeding ten years in both cases.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: What’s clear to me is that simply being invested is by far “the most important thing.” (Someone should write a book with that title!) Most actively managed portfolios won’t outperform the market as a result of manipulation of portfolio weightings or buying and selling for purposes of market timing. You can try to add to returns by engaging in such machinations, but these actions are unlikely to work at best and can get in the way at worst. Most economies and corporations benefit from positive underlying secular trends, and thus most securities markets rise in most years and certainly over long periods. One of the longest-running U.S. equity indices, the S&P 500, has produced an estimated compound average return over the last 90 years of 10.5% per year. That’s startling performance. It means $1 invested in the S&P 500 90 years ago would have grown to roughly $8,000 today. Many people have remarked on the wonders of compounding. For example, Albert Einstein reportedly called compound interest “the eighth wonder of the world.” If $1 could be invested today at the historic compound return of 10.5% per year, it would grow to $147 in 50 years. One might argue that economic growth will be slower in the years ahead than it was in the past, or that bargain stocks were easier to find in previous periods than they are today.

In the past, returns have often been similarly concentrated in a small number of days. Nevertheless, overactive investors continue to jump in and out of the market, incurring transactions costs and capital gains taxes and running the risk of missing those “sharp bursts.” As mentioned earlier, investors often engage in selling because they believe a decline is imminent and they have the ability to avoid it. The truth, however, is that buying or holding – even at elevated prices – and experiencing a decline is in itself far from fatal. Usually, every market high is followed by a higher one and, after all, only the long-term return matters. Reducing market exposure through ill-conceived selling – and thus failing to participate fully in the markets’ positive long-term trend – is a cardinal sin in investing. That’s even more true of selling without reason things that have fallen, turning negative fluctuations into permanent losses and missing out on the miracle of long-term compounding. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: wealth accumulation. Thus, most investors would be better off ignoring short-term considerations if they want to enjoy the benefits of long-term compounding. Two of the six tenets of Oaktree’s investment philosophy say (a) we don’t base our investment decisions on macro forecasts and (b) we’re not market timers. I told the London audience our main goal is to buy debt or make loans that will be repaid and to buy interests in companies that will do well and make money. None of that has anything to do with the short term. From time to time, when we consider it warranted, we do vary our balance between aggressiveness and defensiveness, primarily by altering the size of our closed-end funds, the pace at which we invest, and the level of risk we’ll accept. But we do these things on the basis of current market conditions, not expectations regarding future events. Everyone at Oaktree has opinions on the short-run phenomena mentioned above. We just don’t bet heavily that they’re right. During our recent meetings with clients in London, Bruce Karsh and I spent a lot of time discussing the significance of the short-term concerns. Here’s how he followed up in a note to me: . . . Will things be as bad or worse or better than expected? Unknowable . . . and equally unknowable how much is priced in, i.e. what the market is truly expecting.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Of critical importance, equity investors should make their primary goals (a) participating in the secular growth of economies and companies and (b) benefiting from the wonder of compounding. Think about the 10.5% yearly return of the S&P 500 Index (or its predecessors) since 1926 and the fact that this would have turned $1 into over $13,000 by now, even though the period witnessed 16 recessions, one Great Depression, several wars, one World War, a global pandemic, and many instances of geopolitical turmoil. Think of participating in the long-term performance of the average as the main event and the active efforts to improve on it as “embroidery around the edges.” This might be the reverse of most active investors’ attitudes. Improving results through over- and underweighting, short-term trading, market timing, and other active measures isn’t easy. Believing you can do these things successfully requires the assumption that you’re smarter than a bunch of very smart people. Think twice before proceeding, as the requirements for success are high (see below). Don’t mess it up by over-trading. Think of buying and selling as an expense item, not a profit center. I love the idea of the automated factory of the future, with its one man and one dog; The dog’s job is to keep the man from touching the machinery, and the man’s job is to feed the dog.

Rather, if an investor has studied a company, reached a deep understanding of it and concluded that it possesses great potential for growth and profitability, he’ll probably recognize that it’s impossible to accurately quantify that potential and know when it has been realized. He also may realize that ultimate potential is a moving target, as the company’s strengths may allow it to develop additional avenues of growth. Thus he might have to accept that the correct approach is to (a) hope he has the direction and quantum approximately right, (b) buy and (c) hold on as long as the evidence suggests the thesis is right and the trend is upward – in other words, as long as there’s still juice in the orange. My 2015 memo Liquidity included some observations from Andrew regarding point “c”: When you find an investment with the potential to compound over a long period of time, one of the hardest things is to be patient and maintain your position as long as doing so is warranted on the basis of the prospective return and risk. Investors can easily be moved to sell by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of a new, seemingly more promising idea. When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell. He hasn’t changed his tune one bit over the last five years.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: prospective return is only modestly attractive, (c) she realizes something in her investment thesis was incorrect or has changed for the worse or (d) she fears that the gains to date might be proved unwarranted and thus evaporate; in particular, she’s afraid she’ll end up kicking herself for not having taken profits while they were there. But fear of making a mistake is a terrible reason to sell something of value. Here’s how Andrew puts it today: It’s important to understand the paramount importance of compounding, and how rare and special long-term compounders are. This is antithetical to the “it’s up, so sell” mentality but, in my opinion, critical to long-term investment success. As Charlie Munger says, “the first rule of compounding is to never interrupt it unnecessarily.” In other words, if you have a compounding machine with the potential to do so for decades, you basically shouldn’t think about selling it (unless, of course, your thesis becomes less probable). Compounding at high rates over an investment career is very hard, but doing it by finding something that doubles, then moving on to another thing that doubles, and so on and so on is, in my opinion, nearly impossible. It requires that you develop correct insights about a large number of investment situations over a long period of time. It also requires that you execute well on both the buy and the sell each time.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: it didn’t have potential for exponential growth. But note that Coke holders did earn a compound return of 16% percent a year for 26 years even if they bought at the 1972 pre-crash high. So, even without the growth prospects of today’s best businesses, companies that can compound earnings at high rates can merit very high p/e ratios. H: Aren’t you concerned that if the leading stocks of today go out of style, you could see XYZ down a third or more? A: Stocks can go in and out of style, causing their prices to fluctuate wildly. And when a group is in vogue, it may be more likely to experience a reversal. But, at the end of the day, all I care about is this specific company and its long-term potential which, even when using conservative assumptions, I find to be immense relative to its current price. Seeing it fall wouldn’t be fun, but I think selling here and missing out on part of that future would be far worse. Some years XYZ may do well, and some years it may do poorly (even perhaps very poorly). But if I’m right, I think it has a great long-term future ahead of it. The only way to be sure we participate in that future is to hold on throughout. And, by the way, if you don’t sell, you get to compound without paying capital gains taxes until the end. H: You run a concentrated portfolio. XYZ was a big position when you invested, and it’s even bigger today, given the appreciation.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients Only From: Howard Marks Re: Latest Update I’m going to do all I can to provide information and views throughout this crisis, albeit perhaps without the kind of narrative or literary flourish I usually try for. Flattening the Curve The spread of the virus has been described as “exponential.” Most people use this word without understanding precisely what it means. In short, exponential growth is the real-world version of what people in our business refer to as compounding. In other words, there’s a growth percentage, and the parameter in question increases by that percentage every period. Thus the rate of growth is constant, but the magnitude of the increase grows in each period. For years, we’ve talked about things on the Internet “going viral.” This is what exponential growth means. If the number of daily new cases grows at a constant 10% (almost certainly a substantial understatement in the current case), and we start with 100 new cases on day 1, there will be 110 new cases on day 2; 121 on day 3; 133 on day 4; and 146 on day 5. The ultimate potential number of daily new cases is ugly. If the number of new cases continues to grow at 10% per day, there will be 1,745 new cases on day 31. (I’m very sorry to have to write about a number like that.) Short-term success in fighting the virus isn’t described in terms of eliminating the disease but rather “flattening the curve.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: would “compound.” Because new cases would rise each day by a constant percentage, their number would increase as the fixed growth rate was applied to an expanding base. In order to get the disease under control, the following progression has to take place: • The growth in the number of daily new cases has to come in below expectations, meaning the rate of growth has to decline rather than remain constant. • Then the number of daily new cases has to stabilize, meaning the rate of growth is declining. • Then the number of daily new cases has to decline, meaning the rate of growth is negative. • Then the number of daily new cases has to go to zero, meaning the disease has been stopped. Different places around the world and in the U.S. are at different stages in this progression. There are places where the number of daily new cases is continuing to rise; places where the curve is flattening and the new cases are declining (e.g., trends are positive in U.S. cities that were beset early); and places that had good results early but are seeing rebounds as rules are relaxed and people start to return to their normal behavior. Here are a few of the questions that bear on the outlook for the curve: • Will testing and contact mapping facilitate keeping infected people out of circulation? • Will large numbers of asymptomatic infections impede the effort to isolate carriers?

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: bonds tripling in just four and a half weeks. And yes, the Fed and the Treasury seem to have averted a depression and put us on the path to recovery. But was there justification for the stock market’s 45% gain from the low and the halving of high yield bond yields from their high? And were the resulting security prices appropriate? In other words, some recovery was not unreasonable, but was the magnitude of the one that occurred justified? Of course, the answers to these questions lie in the eye of the beholder. If there were a straightforward, reliable and universally accepted way to arrive at appropriate security prices, (a) securities would likely sell at or near those prices and (b) over-optimistic highs and over- pessimistic lows wouldn’t be reached. But the most optimistic psychology is always applied when things are thought to be going well, compounding and exaggerating the positives, and the most depressed psychology is applied when things are going poorly, compounding the negatives. This guarantees that extreme highs and lows will always be the eventual result in cycles, not the exception. (For a few hundred pages more on this subject, see my 2018 book, Mastering the Market Cycle: Getting the Odds on Your Side.) Maybe it’s the increased availability of information and opinion; maybe it’s the popularization of investing; and maybe it’s the vastly increased emphasis on short-term performance.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: would get a decline for the year of 22.5%. Or if we (incorrectly) added them together, ignoring the impact of compounding, we would get a decline of 16.3%. But MS expects full-year 2020 GDP to be down only 5.3% year-over-year and 6.2% Q4-over-Q4. So what I’ve learned is that annualized quarter-over-quarter changes are quite meaningless, including Q2’s reported decline of 32.9%. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED

The Impact of Negative Rates A quote attributed to Albert Einstein in various forms is relevant to this discussion. Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it. (RateCity) © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Under compound interest, by not withdrawing interest as it is earned, not only does an investor earn interest on his principal year after year (as with simple interest), but each year he also earns interest on the interest that was earned in the preceding years. Thus principal can grow powerfully if left invested for a long period. (At 10%, $100 grows to $300 in 20 years under simple interest, but to $673 if allowed to compound.) What a wonder! There’s one problem, however. The miracle of compound interest works in reverse if the interest rate is negative, making Einstein wrong about its virtue. Who would want to reinvest income at negative rates? And where would income come from for that purpose? It’s not just Einstein’s observation that may be rendered invalid. Negative rates turn a lot of the usual processes upside down. Here are several examples:  Negative rates make life more difficult in a TINA (“there is no alternative”) world. Many investors don’t want to knowingly sign on for negative rates. That makes risky investments preferable, even if they promise historically low prospective returns. In this way, risk aversion is discouraged. “I have no choice but to go into risky assets, because I can’t accept a negative return on safe ones.” There is clear evidence that this is happening among institutional investors.

And second, you surely can’t look at their current growth and pronounce negative rates a huge success. Are negative rates stimulating demand, or are they a matter of “pushing on a string,” powerless to convince pessimistic consumers to spend? In the financial world, most of our actions are based on the assumption that the future will be a lot like the past. Positive interest rates and the desirability of compounding have been among the most fundamental historical building blocks. If negative rates become more widespread across the globe, then the financial system needs to be rebuilt on a new set of assumptions. The problem is that we do not yet know what those should be or how they would work. (Jim Bianco, op. cit.) At minimum, negative rates mean there’s increased uncertainty, and thus we have to proceed with more trepidation. Whatever we knew in the past about how things worked, I think we know less when rates are negative. Will the U.S. See Negative Interest Rates? As stated above, the vast majority of today’s negative-yield bonds are in Europe and Japan. One of the biggest questions surrounds whether negative rates will reach the U.S. This question takes me back to my immediate response to Ian’s suggestion that I write this memo: nobody knows, and certainly not me. When something hasn’t happened in the past, it’s impossible to be sure you know how it’ll end up. Different people will express opinions on © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: This is a very important point. If you believe the market has some special insight that exceeds the collective insight of its participants, then you and I have a fundamental disagreement. The thinking of the crowd isn’t synergistic. In my view, the investment IQ of the market isn’t any higher than the average IQ of the participants. And everyone who transacts gets a volume-weighted vote in setting an asset’s price at a given point in time. People of all different levels of ability act together to set the price. They vary all over the lot in terms of knowledge, experience, insight and emotionalism. The market doesn’t give the ones who are superior in these regards any more influence than the others, especially in the short run. My bottom line on this subject is that the market price merely reflects the average insight of the market participants. That’s point number one. If anything, I think it’s emotion that’s synergistic. It builds into herd behavior or mass hysteria. When 10,000 people panic, the emotion seems to snowball. People influence each other, and their emotions compound, so that the overall level of panic in the market can be higher than the panic of any participant in isolation. That’s something I’ll return to later. Now let’s think about the first goal of investing: to buy low.

© Oaktree Capital Management, L.P. All Rights Reserved conviction, under the assumption that it would be easy and cheap to get out. Here’s a great quote on the subject from Warren Buffett: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value. o Certainly owners of companies wouldn’t (and couldn’t) trade in and out of them every day. If you intend to invest in businesses based on their fundamentals – rather than trading based on short-term market dynamics – it’s critical to think and act like a long-term owner. o When you find an investment with the potential to compound over a long period of time, one of the hardest things is to be patient and maintain your position as long as doing so is warranted on the basis of the prospective return and risk. Investors can easily be moved to sell by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of a new, seemingly more promising idea. When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell. An abundance of liquidity can be a handicap in this regard. Here’s some more good advice from Warren: “If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.

” The truth is that the U.S. has pressing fiscal problems, stretching as far as the eye can see:  in the short term, the “fiscal cliff,” in which already-mandated tax increases and spending cuts have the potential to take 4% off of GDP if nothing is done about them within the next six weeks,  in the medium term, trillion-dollar deficits unless there’s radical improvement, and  in the long term, entitlement promises that absolutely cannot be met. (With millions of Baby Boomers entering their senior years and living longer, we cannot afford the pensions and healthcare benefits that have been promised. The math is inescapable. If these programs are left unchanged, Social Security benefits will grow inexorably, and spending on healthcare has the potential to escalate without limitation.) The bottom line is that if we don’t want to be Greece, we can’t act like Greece. Something has to be done . . . and soon. Every year in which we add another trillion dollars to the national debt (and tens of billions to the annual interest bill) – and every year the excessive entitlement promises are allowed to compound – makes it harder to solve the problem. Vote “No” on Gridlock Political conservatism is associated with a desire for a small federal government, and that often leads to a preference for a divided government and the gridlock that goes with it. The argument is that since government doesn’t do much well, we’re better off if gridlock prevents government from doing much.

In fact, I heard him tell an audience that risk-averse investors should have 80-odd percent of their net worth in stocks, and risk-tolerant investors should have well over 100%. Siegel‟s research contributed to the fervor for equities that characterized the 1990s. And as stocks did better, the appetite for them rose. The period 1995-99 saw a compound average return of 28.6% on the S&P 500, the greatest five years in history. The ardor this reflected was explosive. Arguments were advanced to the effect that stocks – and tech stocks in particular – could only rise, and that they had to rise faster than anything else. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

For example, Ford goes down, giving you a loss, but rather than go down in sympathy (which would give you an offsetting gain on the short position), a favorable development at GM makes it go up, compounding your loss as the hedge goes against you.  Hedging in the wrong amount. You hold 1,000 Ford shares, and you think that – given their likely relative performance – you should short 500 GM shares to hedge your risk. But it turns out that while they move in opposite directions, their relative movements aren’t what you expected. Thus you either hedged too much (and thus you lose more on the hedge than you make on the underlying position) or you hedged too little (so the protection you sought doesn’t materialize). There’s no sure way to choose the right “hedge ratio.”  Time risk. The two sides of the position may work as you expect, but not when you expect. Thus the hedge may fail to work in the short run, meaning the loss on one side of the hedge may occur before the gain on the other, in which case you’ll look flat-out wrong for a while. And if you’re required (by regulation, margin call, capital withdrawals, etc.) to close out the position at that point, the result could be quite negative.  Insufficient liquidity. If conditions or goals change, you might want to adjust or remove your hedge. But market developments in terms of liquidity might make it impossible to alter one or both sides of the position.

performance led to steady increases in the capital allocated to equities, and eventually to the tech stock bubble. It culminated in books such as the fact-based Stocks for the Long Run and the more fanciful Dow 36,000. If you asked institutional investors what return they expected from stocks going forward, I think just about all would have said 11%. An aside: investors consistently seize upon above average returns as an encouraging sign and extrapolate them, and the 17.6% compound return on the S&P 500 from 1979 through 1999 was certainly a case in point. But rarely do they ask what gave rise to those good returns, or what it implies for the future. In essence, stock ownership conveys the benefits of owning a corporation, and stock appreciation should be powered by increases in profits. Thus long-run returns should reflect corporate growth. But as Warren Buffett has pointed out, “. . . people get into trouble when they forget that in the long run, stocks won't appreciate faster than the growth in corporate profits.” Although that growth is the underlying source of equity profits, it is often overshadowed and obscured in the short run by trends in valuation. People took that 17.6% gain as an encouraging sign, overlooking the fact that it stemmed primarily from the rise of p/e ratios described above and thus was unlikely to continue unabated.

address this year: “Government revenues have sagged to 2004 levels and some people say we should just adopt the 2004 budget” – easier said than done when your state’s Medicaid rolls have grown by nearly half a million since then. . . . The states, like the federal government, are facing a demographic headwind that will continue to shrink their tax revenues and compound their growing social safety net obligations. As Graham-Fisher’s Josh Rosner reminds us, the baby boomer’s peak earnings potential is behind them: These boomers are now moving to become the largest tax on the social safety net. The largest generation in U.S. history will retire with less equity in what has historically been the largest retirement and intergenerational wealth transfer asset for most families – their homes. In many cases, these people will have no new [sic] personal savings when they reach the end of their working lives and will essentially become wards of the state. This increased burden on the U.S. Treasury, in a decade, is the largest unconsidered impact of the current crisis. Last year, the states’ fiscal woes were partly assuaged by the federal stimulus package. But nearly 70% of the $787 billion of stimulus funds approved early last year will have been spent by September, according to the CBO.

Until the 1950s, equities always provided higher current yields . . . for the simple reason that they had to. People invested primarily for yield, and riskier securities – stocks – would attract buyers only if they promised higher yields than bonds. This changed in the second half of the 20th century:  Common stock investing was popularized; I believe Charlie Merrill of Merrill Lynch deserves a lot of the credit for this.  Prior to some pioneering computer work at the University of Chicago in the 1960s, the historic returns on stocks had never been scientifically quantified. Then the Center for Research in Security Prices came up with the 9.2% compound annual return that fired many investors’ appetites.  The concept of growth-stock investing was popularized in the 1960s; I remember reading a broker’s brochure about companies with exciting earnings growth. This led to the “nifty-fifty” investing craze, in which investors (and especially bank trust departments) bought the stocks of fast-growing companies regardless of valuation. The equity boom burst in the 1970s.1973-74,

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: You Can’t Eat IRR Until rather recently – certainly up to the early 1980s – “investing” was largely synonymous with “stocks and bonds.” And the performance of a stock or bond portfolio was evaluated in terms of its rate of return. You invested a certain amount of capital, and the percentage by which it increased in a given year was its annual return. To quantify performance over a multi-year period, you chained the individual yearly returns to come up with a compound annual return: Annual Return Dollar Gain Portfolio Value Initial Investment $1,000 Year 1 10% $100 1,100 Year 2 15 165 1,265 Year 3 8 101 1,366 Comp. Ann. Return 11% But in the last few decades, buyout and venture capital funds came along, changing things. Funds like these start with capital commitments, call and invest their capital over time, and thereafter manage and liquidate their portfolios. They expand and contract radically, and in assessing their performance, it’s clear that a given year’s percentage return matters more – and thus should be given more weight – if it was achieved when the fund held a lot of capital (and less if it was not). Investors wisely concluded that the performance of such funds should be assessed using a measure capable of capturing this phenomenon.

They turned to “internal rate of return,” the now-ubiquitous “IRR,” as the yardstick with which to measure results for portfolios that experience significant cash inflows and outflows. In mathematical terms, IRR is the discount rate that sets a fund’s cash outflows equal to its inflows in present value terms. In other words, you list all of the fund’s contributions and distributions and solve for the discount rate that makes them add up to zero. If discounting at 20% accomplishes this, then the amounts received in distributions represent an average advance of 20% per year over the capital contributed, and that’s the fund’s IRR. I’ll provide a simple example on the next page to illustrate the difference that can arise between compound annual return and IRR.

© Oaktree Capital Management, L.P. All Rights Reserved Fund A Annual Return Dollar Gain Distribution Portfolio Value Initial Investment $1,000 Year 1 10% $100 $600 500 Year 2 40 200 650 50 Year 3 100 50 100 -- Comp. Ann. Return 45% IRR 21% The 10% gain in year one, achieved on starting capital of $1,000, produced a $100 gain in the fund’s value. The 100% return in year three, on the other hand, was applied to just $50 of capital, producing a gain of $50. Although the percentage return was much higher in year three, it produced just half the dollar gain as the smaller return in year one. Thus, in calculating the fund’s overall performance, the 100% return should be accorded much less weight than the 10% return. IRR produces that result (whereas compound annual return does not). Because a given year’s annual result is weighted in the IRR calculation by the number of dollars in the fund that year, and thus counts for more when the fund is larger and less when it’s smaller, internal rate of return is referred to as a “dollar-weighted” return. To make the distinction clear, the old compound annual return is now referred to as a “time-weighted” return. This nonsensical term means that every year’s individual return is given the same weight in the calculation. It’s the same as saying “equal-weighted,” or even “unweighted” . . . but “time-weighted” sounds much more scientific. (It’s not for nothing that George Bernard Shaw defined professions as “conspiracies against the laity.

”) For Fund A, shown above, the three-year IRR is 21%. This is far more reflective of the amount of wealth created than is the 45% time-weighted return. The difference arises because the IRR calculation gives relatively little weight to the 100% return achieved in the third year, whereas the time-weighted return gives it as much weight as the first-year gain of 10%. To fully understand the importance of this distinction, consider Fund B, which achieves the same annual returns as Fund A – and thus the same compound annual return – but holds on to all of its capital through the end of the third year. Fund B Annual Return Dollar Gain Distribution Portfolio Value Initial Investment $1,000 Year 1 10% $ 100 0 1,100 Year 2 40 440 0 1,540 Year 3 100 1,540 $3,080 -- Comp. Ann.45

© Oaktree Capital Management, L.P. All Rights Reserved The annual returns are the same for Fund B as for Fund A (and thus so is the three-year compound annual return). But Fund B’s IRR is 45% (the same as its compound annual return, since there weren’t any interim inflows or outflows), while Fund A’s is 21%. The difference arises because Fund B achieved its 100% return in year three with beginning capital of $1,540, as compared with just $50 for Fund A. Fund B produced total distributions of $3,080, while Fund A’s distributions totaled only $1,350. Certainly Fund B’s performance should be considered superior – even though the two funds’ time-weighted returns are the same. Fund B’s superiority is captured by its higher IRR. UBig Percentage Gains on Small Dollars – Real-Life Example #1 I would find it hard to invent examples as extreme as some of those provided by real life. Let’s look at the results for our first distressed debt fund – Special Credits Fund I – in 1996, its last year in business. This fund was formed in October 1988 with committed capital of $96.5 million, which was fully drawn and invested by the end of 1990. It achieved annual before-fee returns ranging between 29% and 89% in 1991-94 and made large distributions in 1992-93. By the end of 1995, its since- inception time-weighted return had reached 23.7%, its IRR stood at 24.0%, and it was down to one asset carried on the books at $1.9 million. So far, a simple picture.

© Oaktree Capital Management, L.P. All Rights Reserved. Perhaps the ultimate description of demographic luck comes from Warren Buffett: I’ve had it so good in this world, you know. The odds were fifty-to-one against me being born in the United States in 1930. I won the lottery the day I emerged from the womb by being in the United States instead of in some other country where my chances would have been way different. Imagine there are two identical twins in the womb, both equally bright and energetic. And the genie says to them, “One of you is going to be born in the United States, and one of you is going to be born in Bangladesh. And if you wind up in Bangladesh, you will pay no taxes. What percentage of your income would you bid to be the one that is born in the United States?” It says something about the fact that society has something to do with your fate and not just your innate qualities. The people who say, “I did it all myself,” and think of themselves as Horatio Alger – believe me, they’d bid more to be in the United States than in Bangladesh. That’s the Ovarian Lottery. (The Snowball, Alice Schroeder) Buffett is insightful enough to realize – and secure enough to admit – that he isn’t solely responsible for his success. What if he’d been born in Bangladesh instead of the U.S.? Or a woman rather than a man in 1930, having much fewer opportunities?