Howard Marks on Diversification

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • The board expressed a strong preference for bearing the “normal” risks stemming from market participation as opposed to the risks associated with an innovative but opaque approach that is projected to deliver returns accompanied by risk below the normal level. • All board members recognized that having true diversification means there may well be some laggards within the portfolio at all times. In my opinion, the consultant covered the most important aspects of risk bearing, and the board members’ views were reasonable. Importantly, they recognize that their conservative bent may lead to under- performance in strong markets, but they explicitly prefer that to a more aggressive posture with its attendant risks. This is probably the most important real-world consideration under the heading of risk attitudes. Not everyone can live happily with the performance lags that conservatism can bring, but this board has had the opportunity to see that in action during the last two bullish years, and it seems to be sticking to the plot. The board members accept that risk isn’t something to be avoided. They’re not looking for the illusive black box that others say will give them return without risk. And they understand that caution limits return potential – and that the staff shouldn’t be criticized for the presence of underperformers when the board says it wants diversification.

stocks and bonds, and there was a time-honored notion that something like 60% equities and 40% bonds represented reasonable diversification. Today, investors are presented with so many choices – and there’s so much emphasis on getting the decision right – that the term “asset allocation” is very prominent, and there are individuals and whole departments dedicated to doing just that. It’s their job to decide how to weight the asset classes to be held in a portfolio, meaning asset allocators spend their time on decisions like these: • How much in equities and how much in debt? • How much in stocks and bonds and how much in “alternatives”? • How much in public securities and how much in private assets? • How much in one’s home country and how much abroad? • How much of the latter in the developed world and how much in emerging markets? • How much in high quality assets and how much in low quality? • How much in more volatile “high beta” assets and how much in steadier ones? • How much in levered strategies and how much unlevered? • How much in “real assets”? • How much in derivatives? It’s enough to make your head spin. Many investors use computer models to help with these decisions, but the models require inputs regarding expected return, risk, and correlation, and most of these are based on history and thus of questionable relevance to the future. Correlation between asset classes is particularly difficult to predict.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Big tech companies dominate the index to an unprecedented degree. Just five of those seven stocks represent nearly a quarter of the market capitalisation of the entire index. (“The seven companies driving the US stock market rally,” Financial Times, June 14, 2023.) The extent of these stocks’ outperformance for much of this year may be unique, but the phenomenon is not. It was also the case in 2017 that a few stocks were largely responsible for carrying the market upward. Then it was the “FAANGs”: Facebook, Amazon, Apple, Netflix, and Google/Alphabet. The Financial Times highlighted this history as well: Top-heaviness, particularly in US markets, is not new. “The big tech stocks in the S&P now are the same situation as oil companies were in the past, or the Nifty 50 in the 1960s,” says Frédéric Leroux, head of the cross-asset team at Carmignac in Paris – a nod to the craze that swept shares in a small number of fast-growing companies such as IBM, Kodak and Xerox higher before a heavy decline set in. “It’s a problem, but it’s a recurring problem.” (Ibid.) For as long as most of us can remember, active investors have had a tough time keeping up with the equity indices. For this reason, in recent decades, passive investing has taken a substantial share of equity capital invested.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • The performance of the equity indices is often dominated by a few stocks or groups of stocks. • The gains of the leaders can make them seem expensive, arguing for profit-taking. • Human nature – especially the desire to avoid regret – adds to the motivation to sell. • By definition, if you reduce your holdings of the winners relative to their representation in the indices and these winners continue to outperform, you’ll have a tough time keeping up. In my memo Liquidity (March 2015), I included an insight from my son Andrew. To paraphrase, he said, “If you look at the chart of a stock that’s been up for 25 years and say, ‘Man, I wish I’d owned that stock,’ think about all the days you would have had to talk yourself out of selling.” I doubt many people watched Apple go from $0.37 to $180 without selling any. How many active investors would allow Apple shares to constitute nearly 8% of their portfolios, which was its weight in the S&P 500 at the recent peak? But – to oversimplify – if they sold Apple, they’ve lagged. The bottom line is that winners aren’t entirely dispensable. If you hope to at least keep up with the indices, you probably have to have an average representation in them. (This isn’t entirely inescapable. You might also achieve that goal by holding fewer of the losers.) The Role of Risk Bearing I’m going to conclude this memo using my favorite graph.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Here’s a related question from my reconstructed conversation with Andrew: H: You run a concentrated portfolio. XYZ was a big position when you invested, and it’s even bigger today, given the appreciation. Intelligent investors concentrate portfolios and hold on to take advantage of what they know, but they diversify holdings and sell as things rise to limit the potential damage from what they don’t know. Hasn’t the growth in this position put our portfolio out of whack in that regard? A: Perhaps that’s true, depending on your goals. But trimming would mean selling something I feel immense comfort with based on my bottom-up assessment and moving into something I feel less good about or know less well (or cash). To me, it’s far better to own a small number of things about which I feel strongly. I’ll only have a few good insights over my lifetime, so I have to maximize the few I have. All professional investors want good investment performance for their clients, but they also want financial success for themselves. And amateurs have to invest within the limits of their risk tolerance. For these reasons, most investors – and certainly most investment managers’ clients – aren’t immune to apprehension regarding portfolio concentration and thus susceptibility to untoward developments.

I certainly think public security prices reflect psychological swings that are often excessive. Should the prices of private investments emulate this? As with most things, any inaccuracy in reporting will eventually come to light. Eventually, private debt will mature, and private equity holdings will have to be sold. If the returns being reported this year understate the real declines in value, performance from here on out will likely look surprisingly poor. And I’m sure this will lead plenty of academics (and maybe a few regulators) to question whether the pricing of private investments in 2022 was too high. We’ll see. What Doesn’t Matter: Hyper-Activity In Selling Out (January 2022), I expressed my strong view that most investors trade too much. Since it’s hard to make multiple consecutive decisions correctly, and trading costs money and is often likely to result from an investor’s emotional swings, it’s better to do less of it. When I was a boy, there was a popular saying: Don’t just sit there; do something. But for investing, I’d invert it: Don’t just do something; sit there. Develop the mindset that you don’t make money on what you buy and sell; you make money (hopefully) on what you hold. Think more. Trade less. Make fewer, but more consequential, trades. Over-diversification reduces the importance of each trade; thus it can allow investors to take actions without adequate investigation or great conviction. I think most portfolios are overdiversified and over-traded.

Clearly, this is very different from equities, where your upside is theoretically unlimited, requiring that investors intelligently balance downside risk and upside potential. To be a good equity investor, I think you have to be an optimist; certainly, it’s no activity for doomsayers. On the other hand, the term “optimistic bond investor” is practically an oxymoron. Since bonds generally lack potential for long-term returns in excess of their promised yields, bond investing mostly requires skepticism and attention to the downside. One of the reasons I did well in fixed income is that it played to my natural conservatism. And since tech companies issue relatively few bonds, it also accommodated my lack of focus on technology, which has never been of particular interest to me and has always felt a bit “over my head.” I’m certainly not an “early adopter,” nor do I have a history of recognizing emerging technological trends in their infancy. Lastly, as a child of parents who were born in the early 1900s and thus were adults during the Great Depression, my thought process was shaped by the deprivation and fear they had experienced. Because they had been made so painfully aware of the value of a dollar and how quickly things could change for the worse, they considered the future and the possibility of loss things to worry about. Adages like “don’t put all your eggs in one basket” and “save for a rainy day” were watchwords I grew up with.

It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual. Finally, the systemic risks to the stock market have to be considered. Bregman calls “the index universe a big, crowded momentum trade.” A handful of stocks – the FAANGs and a few more – are responsible for a rising percentage of the S&P’s gains, meaning the stock market’s health may be overstated. All the above factors raise questions about the likely effectiveness of passive vehicles – and especially smart-beta ETFs.  Is Apple a safe stock or a stock that has performed well of late? Is anyone thinking about the difference?  Are investors who invest in a number of passive vehicles described in different ways likely to achieve the diversification, liquidity and safety they expect?  And what should we think about the willingness of investors to turn over their capital to a process in which neither individual holdings nor portfolio construction is the subject of thoughtful analysis and decision-making, and in which buying takes place regardless of price? Credit Corporate debt instruments are good candidates for spotting bull-market behavior given that (unlike equities, for example), we can readily determine their prospective returns.

 Adding risky assets to a portfolio makes it riskier – One of Nobel prize-winner William Sharpe’s greatest contributions to investment theory came in the realization that if a portfolio holds only low-risk assets, the addition of a risky asset can make it safer. This happens because doing so increases the portfolio’s diversification and reduces the correlation among its components, reducing its vulnerability to a single negative development.  It’s desirable that everything in a well-diversified portfolio performs well – The truth is, if all the holdings were to perform well in one scenario, they could all perform poorly in another. That means the benefits of diversification wouldn’t be enjoyed. It shouldn’t be surprising – or totally disappointing – to have some laggards in a portfolio that’s truly well-diversified.  Understanding the science of economics will enable you to safely harness the macro future – There are no immutable rules in play. “In economics and investments, because of the key role played by human nature, you just can’t say for sure that ‘if A, then B,’ as you can in real science. The weakness of the connection between cause and effect makes outcomes uncertain. In other words, it introduces risk.” (“Risk Revisited,” September 2014).  Sometimes the outlook is clear, and sometimes it’s complicated and unpredictable. You have to be careful when it’s the latter – The truth is, the future is never worry-free.

In that case, success may hinge entirely on the avoidance of unconventional behavior that’s unsuccessful. Often the best way to choose between alternative courses of action is by figuring out which has the highest “expected value”: the total value arrived at by multiplying each possible outcome by its probability of occurring and summing the results. As I learned from my first textbook at Wharton fifty years ago (Decisions Under Uncertainty by C. Jackson Grayson, Jr.), if one act has a higher expected value than another and “. . . if the decision maker is willing to regard the consequences of each act-event in purely monetary terms, then this would be the logical act to choose. Keeping in mind, however, that only one event and its consequence will occur (not the weighted average consequence),” agents may not be able to choose on the basis of expected value or the weighted average of all possible consequences. If a given action has potential bad consequences that are absolutely unacceptable, the expected value of all of its consequences – both good and bad – can be irrelevant. Given the typical agent’s asymmetrical payoff table, the rule for institutional investors underlined above is far from nonsensical. But if it is adopted, this should be done with awareness of the likely result: over-diversification. This goes all the way back to the beginning of this memo, and each organization’s need to establish its creed.

It wouldn’t make sense to voluntarily bear incremental credit risk if either of these two beliefs were lacking.  Another way to access attractive returns in today’s low-rate environment is to bear illiquidity risk in order to take advantage of investors’ normal dislike for illiquidity (superior returns often follow from investor aversion). Institutions that held a lot of illiquid assets suffered considerably in the crisis of 2008, when they couldn’t sell them; thus many developed a strong aversion to them and in some cases imposed limitations on their representation in portfolios. Additionally, today the flow of retail money is playing a big part in driving up asset prices and driving down returns. Since retail money has a harder time making its way to illiquid assets, this has made the returns on the latter appear more attractive. It’s noteworthy that there aren’t mutual funds or ETFs for many of the things we’re investing in.  Some strategies introduce it voluntarily and some can’t get away from it: concentration risk. “Everyone knows” diversification is a good thing, since it reduces the impact on results of a negative development. But some people eschew the safety that comes with diversification in favor of concentrating their investments in assets or with managers they expect to outperform. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved And some investment strategies don’t permit full diversification because of the limitations of their subject markets. Thus problems – if and when they occur – will be bigger per se.  Especially given today’s low interest rates, borrowing additional capital to enhance returns is another way to potentially increase returns. But doing so introduces leverage risk. Leverage adds to risk two ways. The first is magnification: people are attracted to leverage because it will magnify gains, but under unfavorable outcomes it will magnify losses instead. The second way in which leverage adds to risk stems from funding risk, one of the classic reasons for financial disaster. The stage is set when someone borrows short-term funds to make a long-term investment. If the funds have to be repaid at an awkward time – due to their maturity, a margin call, or some other reason – and the purchased assets can’t be sold in a timely fashion (or can only be sold at a depressed price), an investment that might otherwise have been successful can be cut short and end in sorrow. Little or nothing may remain of the sale proceeds once the leverage has been repaid, in which case the investor’s equity will be decimated. This is commonly called a meltdown. It’s the primary reason for the saying, “Never forget the six-foot- tall man who drowned crossing the stream that was five feet deep on average.

I touched above on concentration risk, but we should also think about the flip side: the risk of over- diversification. If you have just a few holdings in a portfolio, or if an institution employs just a few managers, one bad decision can do significant damage to results. But if you have a very large number of holdings or managers, no one of them can have much of a positive impact on performance. Nobody invests in just the one stock or manager they expect to perform best, but as the number of positions is expanded, the standards for inclusion may decline. Peter Lynch coined the term “diworstification” to describe the process through which lesser investments are added to portfolios, making the potential risk- adjusted return worse. While I don’t think volatility and risk are synonymous, there’s no doubt that volatility does present risk. If circumstances cause you to sell a volatile investment at the wrong time, you might turn a downward fluctuation into a permanent loss. Moreover, even in the absence of a need for liquidity, volatility can prey on investors’ emotions, reducing the probability they’ll do the right thing. And in the short run, it can be very hard to differentiate between a downward fluctuation and a permanent loss. Often this can really be done only in retrospect. Thus it’s clear that a professional investor may have to bear consequences for a temporary downward fluctuation simply because of its resemblance to a permanent loss.

, unlike the general future, credit risk can be gauged by experts (like us) and reduced through credit selection. It wouldn’t make sense to voluntarily bear incremental credit risk if either of these two beliefs were lacking.  Another way to access attractive returns in today’s low-rate environment is to bear illiquidity risk in order to take advantage of investors’ normal dislike for illiquidity (superior returns often follow from investor aversion). Institutions that held a lot of illiquid assets suffered considerably in the crisis of 2008, when they couldn’t sell them; thus many developed a strong aversion to them and in some cases imposed limitations on their representation in portfolios. Additionally, today the flow of retail money is playing a big part in driving up asset prices and driving down returns. Since retail money has a harder time making its way to illiquid assets, this has made the returns on the latter appear more attractive. It’s noteworthy that there aren’t mutual funds or ETFs for many of the things we’re investing in.  Some strategies introduce it voluntarily and some can’t get away from it: concentration risk. “Everyone knows” diversification is a good thing, since it reduces the impact on results of a negative development. But some people eschew the safety that comes with diversification in favor of concentrating their investments in assets or with managers they expect to outperform.

© Oaktree Capital Management, L.P. All Rights Reserved Correlation is the degree to which an asset’s price will move in sympathy with the movements of others. The higher the correlation among its components, all other things being equal, the less effective diversification a portfolio has, and the more exposed it is to untoward developments. An asset doesn’t have “a correlation.” Rather, it has a different correlation with every other asset. A bond has a certain correlation with a stock. One stock has a certain correlation with another stock (and a different correlation with a third). Stocks of one type (such as emerging market, high-tech or large-cap) are likely to be highly correlated with others within their category, but they may be either high or low in correlation with those in other categories. Bottom line: it’s hard to estimate the riskiness of a given asset, but many times harder to estimate its correlation with all the other assets in a portfolio, and thus the impact on performance of adding it to the portfolio. This is a real art. Fixed income investors are directly exposed to another form of risk: interest rate risk. Higher interest rates mean lower bond prices – that relationship is absolute. The impact of changes in interest rates on asset classes other than fixed income is less direct and less obvious, but it also pervades the markets. Note that stocks usually go down when the Fed says the economy is performing strongly. Why?

And some investment strategies don’t permit full diversification because of the limitations of their subject markets. Thus problems – if and when they occur – will be bigger per se.  Especially given today’s low interest rates, borrowing additional capital to enhance returns is another way to potentially increase returns. But doing so introduces leverage risk. Leverage adds to risk two ways. The first is magnification: people are attracted to leverage because it will magnify gains, but under unfavorable outcomes it will magnify losses instead. The second way in which leverage adds to risk stems from funding risk, one of the classic reasons for financial disaster. The stage is set when someone borrows short-term funds to make a long-term investment. If the funds have to be repaid at an awkward time – due to their maturity, a margin call, or some other reason – and the purchased assets can’t be sold in a timely fashion (or can only be sold at a depressed price), an investment that might otherwise have been successful can be cut short and end in sorrow. Little or nothing may remain of the sale proceeds once the leverage has been repaid, in which case the investor’s equity will be decimated. This is commonly called a meltdown. It’s the primary reason for the saying, “Never forget the six-foot- © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

 As an asset declines in price, making people view it as riskier, it becomes less risky (all else being equal).  As an asset appreciates, causing people to think more highly of it, it becomes riskier.  Holding only “safe” assets of one type can render a portfolio under-diversified and make it vulnerable to a single shock.  Adding a few “risky” assets to a portfolio of safe assets can make it safer by increasing its diversification. Pointing this out was one of Professor William Sharpe’s great contributions. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

The fact that an investment is susceptible to a serious negative development that will occur only infrequently – what I call “the improbable disaster” – can make it appear safer than it really is. Thus after several years of a benign environment, a risky investment can easily pass for safe. That’s why Warren Buffett famously said, “. . . you only find out who’s swimming naked when the tide goes out.” Assembling a portfolio that incorporates risk control as well as the potential for gains is a great accomplishment. But it’s a hidden accomplishment most of the time, since risk only turns into loss occasionally . . . when the tide goes out. The fourth is that risk is multi-faceted and hard to deal with. In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over- diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:  Efforts to reduce the risk of losing money invariably increase the risk of missing out.

© Oaktree Capital Management, L.P. All Rights Reserved  However, in order to succeed they’ll all require a high level of skill from their managers in identifying return prospects and keeping risk under control. Thus they all entail manager risk. Our response is to entrust these portfolios only to managers who’ve been with us for years. It’s reasonable – essential, really – to study the risk entailed in every investment and accept the amounts and types of risk that you’re comfortable with (assuming this can be discerned). It’s not reasonable to expect highly superior returns without bearing some incremental risk. I touched above on concentration risk, but we should also think about the flip side: the risk of over- diversification. If you have just a few holdings in a portfolio, or if an institution employs just a few managers, one bad decision can do significant damage to results. But if you have a very large number of holdings or managers, no one of them can have much of a positive impact on performance. Nobody invests in just the one stock or manager they expect to perform best, but as the number of positions is expanded, the standards for inclusion may decline. Peter Lynch coined the term “diworstification” to describe the process through which lesser investments are added to portfolios, making the potential risk- adjusted return worse. While I don’t think volatility and risk are synonymous, there’s no doubt that volatility does present risk.

Valuation risk should be easily combatted, since it’s largely within the investor’s control. All you have to do is refuse to buy if the price is too high given the fundamentals. “Who wouldn’t do that?” you might ask. Just think about the people who bought into the tech bubble. Fundamental risk and valuation risk bear on the risk of losing money in an individual security or asset, but that’s far from the whole story. Correlation is the essential additional piece of the puzzle. Correlation is the degree to which an asset’s price will move in sympathy with the movements of others. The higher the correlation among its components, all other things being equal, the less effective diversification a portfolio has, and the more exposed it is to untoward developments. An asset doesn’t have “a correlation.” Rather, it has a different correlation with every other asset. A bond has a certain correlation with a stock. One stock has a certain correlation with another stock (and a different correlation with a third). Stocks of one type (such as emerging market, high-tech or large-cap) are likely to be highly correlated with others within their category, but they may be either high or low in correlation with those in other categories. Bottom line: it’s hard to estimate the riskiness of a given asset, but many times harder to estimate its correlation with all the other assets in a portfolio, and thus the impact on performance of adding it to the portfolio. This is a real art.

” At first this doesn’t seem to have much legitimacy, but it can be about the possibility that the economy may catch fire and do better than expected, earnings may come in above consensus, or the stock market may appreciate more than people think. Since these things are positives, there’s risk in being underexposed to them. * * * To move to the biggest of big pictures, I want to make a few over-arching comments about risk. The first is that risk is counterintuitive.  The riskiest thing in the world is the widespread belief that there’s no risk.  Fear that the market is risky (and the prudent investor behavior that results) can render it quite safe.  As an asset declines in price, making people view it as riskier, it becomes less risky (all else being equal).  As an asset appreciates, causing people to think more highly of it, it becomes riskier.  Holding only “safe” assets of one type can render a portfolio under-diversified and make it vulnerable to a single shock.  Adding a few “risky” assets to a portfolio of safe assets can make it safer by increasing its diversification. Pointing this out was one of Professor William Sharpe’s great contributions. The second is that risk aversion is the thing that keeps markets safe and sane.  When investors are risk-conscious, they will demand generous risk premiums to compensate them for bearing risk.

In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over- diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:  Efforts to reduce the risk of losing money invariably increase the risk of missing out.  Efforts to reduce fundamental risk by buying higher-quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics. At bottom, it’s the inability to arrive at a single formula that simultaneously minimizes all the risks that makes investing the fascinating and challenging pursuit it is. The fifth is that the task of managing risk shouldn’t be left to designated risk managers. I’m convinced outsiders to the fundamental investment process can’t know enough about the subject assets to make appropriate decisions regarding each one. All they can do is apply statistical models and norms.

© Oaktree Capital Management, L.P. All Rights Reserved. had come not from the value added by a dependable process, but from the fact that in essence the futures had allowed people to be more than 100% invested in a rising market.  And more recently, “risk parity investing” worked through volatile times because it gave its followers greater strategic diversification, defensiveness and bond exposure than most other investors had. But it, like most other things, failed to prevent losses when Ben Bernanke spooked the market by threatening to ease off bond buying and let interest rates rise. This year’s results for risk parity show that nothing works all the time. The point is that no mechanical tools can enable investors to prosper under all circumstances. They can provide tilts or reduce exposures, but the tool that promises a mix of good results and great results without the possibility of bad results is too good to be true. And when excessive confidence develops in such things, investors are heading for trouble. The same is true for the Greenspan put and its successor, the Bernanke put. Alan Greenspan’s tenure as Fed chairman was marked by efforts to avoid problems by injecting liquidity and lowering interest rates. Investors put great stock in his ability to keep things moving ever upward. His policies prevented occasional corrections along the way, but the price paid was a big one: the financial crisis of 2008.

Working with CIOs Landis Zimmerman (now at Howard Hughes Medical Institute) in the early years and especially closely with Kristin Gilbertson in 2004-2010, the Investment Board and I led gradual diversification into growth stocks, emerging markets and defense-oriented hedge funds, with an emphasis on managers stressing risk-control. We established an allocation for private equity but implemented it very slowly. We kept an above-average percentage of the portfolio in publicly traded securities. And, importantly, we maintained a substantial allocation to cash and U.S. Treasurys, solely to enable us to meet the need for cash for operations and thereby avoid having to sell assets in a time of depressed prices. The Results The performance produced by these decisions was quite predictable. With its low-risk portfolio, Penn outperformed when risk taking was penalized but trailed when risk taking was rewarded. It outperformed when value stocks did well but lagged when more aggressive tools, including leverage and portable alpha, paid off. For the decade overall it lagged the average of its peer institutions by a small margin and exhibited lower volatility. No surprise there. Penn’s return was about 5½% for FY2001-10, while most of its peers made 6% or 7%. But average results don’t tell the whole story. It’s important to remember one of my favorite adages, about the six-foot-tall man who drowned crossing the stream that was five feet deep on average.

With the panic now gone, stocks have recovered, but only about half their 2007-09 losses. The S&P 500 stands at a level that was first reached in 1998, meaning over the last twelve years, the average stockholder’s paltry return of less than a percent a year came entirely from dividends. People talk about the “lost decade in equities,” and still no one seems to feel he owns too few stocks. A Brief History of Bonds The recent history of bonds requires less telling. Bonds were the bedrock of investment portfolios in the first half of the last century. Along with Treasurys, utilities and corporates, business was brisk in railroad and streetcar bonds. Graham and Dodd’s classic, Security Analysis, devoted more than 200 pages to “fixed-value investments” including preferred stock, of which next to nothing is heard today. The story of bonds in the last sixty years is the mirror opposite of what happened to stocks. First bonds wilted as stocks monopolized the spotlight in the 1950s and ’60s, and at the end of 1969, First National City Bank’s weekly summary of bond data died with the heading “The Last Issue” boxed in black. Bonds were decimated in the high-interest-rate environment of the ’70s, and even though interest rates declined steadily during the ’80s and ’90s, bonds didn’t have a prayer of standing up to equities’ dramatic gains. By the time the late 1990s rolled around, any investment in bonds rather than stocks felt like an anchor restraining performance.

© Oaktree Capital Management, L.P. All Rights Reserved Right now, most borrowers are avoiding default, sometimes abetted by lenders practicing “pretend and extend.” What they’re pretending is that commercial real estate loans will be repayable upon maturity. It seems inescapable that over the next few years:  higher vacancy rates and lower rents will keep net operating income from returning to the peak levels of the last cycle,  property buyers won’t go back to finding sufficient risk compensation in pre-crisis cap rates, and  financial institutions aren’t going to lend the same high percentage of property purchase prices as they did 3-4 years ago. Any one of these factors would make it hard for commercial real estate to again command its pre-crisis prices, or for it to be financeable or refinanceable at those levels. Together, the three elements mean many properties are “upside-down” today. That is, their market value is less than the debt against them. Will a $100 million loan secured by an $80 million building be repaid or refinanced? Unlikely. And since that description covers a great deal of commercial real estate today, many real estate loans will go unpaid at maturity. That implies widespread losses for investors and write-downs for lenders. Many small and medium-sized banks have too much local real estate and construction loans in their portfolios. They fell for the myth of safety in real estate and forgot about the need for geographic diversification.

More importantly, I also concluded that since gold has “worked” for hundreds of years, it probably will keep on doing so. It might not do so forever, but what’s the probability this will be the year it stops? So I wouldn’t bet against it, and I might recommend a position “just in case.” Not because I view gold affirmatively as a moneymaker, but rather as a useful contributor to safety through diversification. Surely the uncertain world situation seems to call for all the protection against the unknown that we can amass. Still, the other hand brings me back to price. Yes, gold is probably more likely to continue serving as a store of value than to quit. And yes, maybe one should have a position. But is this the right price at which to start . . . ?2010

Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy. . . . (George Soros, MIT Department of Economics World Economy Laboratory Conference, Washington, D.C., April 26, 1994) My son Andrew, now starting his investment career, has provided an illustration of reflexivity at work that’s clear and topical. For several years prior to the crisis, the desire for high returns with low risk (what else is new?) created strong demand for mortgage-based investment products such as RMBS and CDOs. Underpinning it all was the fact that there had never been a nationwide decline in home prices, and thus participants were confident that geographic diversification would render levered mortgage pools safe, warranting triple-A ratings for most of the resulting securities. Rising demand for these products required an increasing volume of underlying mortgages. This need caused lending standards to be weakened and loans to be provided to home buyers with dubious creditworthiness. Easy financing allowed buyers to bid up home prices to levels that exceeded the homes’ realistic values and made it tough for borrowers to make their mortgage payments. When the perpetual-motion machine of house appreciation ground to a halt in 2007, the combination of too-high prices and record mortgage defaults resulted in the first nationwide decline in home prices.

But such an appraisal obviously says nothing about what a house will bring after being repossessed a few years later. Nevertheless, in recent years, a purchase price of $X, supported by an appraisal of $X, was used to justify lending 95% of $X – or maybe 100% or 105% – when a home was bought or refinanced. No wonder homes valued in the biggest boom in history have turned out to be unreliable collateral. Second, these overrated mortgages were packaged into the most alchemical and fantastic leveraged structures. It is these, not mortgages themselves, that have jeopardized our institutions. There was a limited market for whole mortgage loans; they were considered a specialist market entailing risk and requiring expertise. But supposedly those worries would be obviated if one bought the debt of structured entities that invested in residential mortgage-backed securities (RMBS). First question: where did the risk go? We were told it disappeared thanks to the magic of structuring, tranching and diversifying, permitting vast amounts of leverage to be applied safely. Second question: how reliable was the diversification? Answer: again we were told, highly reliable; there had never been a national decline in home prices, so mortgages could be considered uncorrelated with each other. The performance of a mortgage on a house in Detroit would be unaffected by what went on in Florida or California. (Well, so much for what we were told.)

By the time I got the call described above, Mike had joined Drexel Burnham Lambert, started the high yield bond department, moved it to California and begun to underwrite new issue high yield bonds for corporate borrowers. He visited me at the bank in the fall of 1978, and it was even more of a learning experience than the one I got from the Nifty Fifty. Mike’s logic was the direct opposite, and to me much more appealing. Here’s what he told me:  If you buy triple-A or double-A bonds, there’s only one way for them to go: down. The surprises are invariably negative, and the record shows that few top-rated bonds remain so for very long.  On the other hand, if you buy B-rated bonds and they survive, all the surprises will be on the upside.  Because the investment process is prejudiced against high yield bonds, they offer yields that more than compensate for the risk.  Thus you’ll earn a superior yield for having accepted the incremental credit risk, and favorable developments can lead to capital gains as well.  Your main goal should be to weed out bonds that may default.  But diversification is essential, too, because some of the bonds you hold will default anyway, and your positions in them mustn’t be large enough to jeopardize the overall return. What an object lesson! What an epiphany! Buy the stocks of the best companies in America at prices that assume nothing can go wrong?

© Oaktree Capital Management, L.P. All Rights Reserved quality and caution.” Not all managers succumbed to this temptation, of course, but it was there. CDOs have been among the greatest contributors to the recent upswing. To a large extent they were a bottomless pit that could never be filled, a prime source of demand for debt. Why was their growth so strong? Because they offered a terrific deal, attracting vast quantities of money that had to be invested. What was that deal? Simple: high-rated debt at low-grade yields. Too good to be true? Of course. The ratings were too high because rating agency analysts had to rate exotic structured products with which they had no experience (and probably no true understanding). And I’m confident the CDO managers were very persuasive, using sophisticated statistical models to explain how safe they were thanks to portfolio diversification and over-collateralization. For this reason, many tranches of CDOs stuffed with non-investment grade debt received investment grade ratings, looked cheap based on their attractive promised yields, and thus sold out rapidly. CDOs were among the greatest buyers of residential mortgage-backed securities (RMBS) and non-investment grade leveraged loans. I’ll bet some investors even leveraged up to buy the debt of these highly leveraged entities, which in turn used their capital to buy highly leveraged paper. Could the end be in doubt?

Matthew Rothman of Lehman Brothers has become famous for saying in early August that “events that models only predicted would happen once in 10,000 years happened every day for three days.” Are those models you want to bet on?  UDi-worst-ificationU – Warren Buffett harps on the folly of branching out into things you know less about solely for the purpose of increasing the number of baskets in which you have your eggs. Investing in things about which you aren’t expert doesn’t reduce risk, it increases it. And I think it’s particularly unwise to finance diversification with borrowed money.  UConflicts between managers and clientsU – Investors should look very closely at the alignment of their managers’ interests with their own. The mere fact that a manager is working for incentive compensation, or has money in his fund, isn’t enough. Recent events have shed some unusual – and provocative – light on the question of alignment. Consider Sowood Capital, which lost half of its investors’ capital, sold off its portfolio in a block and closed down. Why did the loss of half the LPs’ equity occasion a liquidation? Might further losses have activated a clawback of previous years’ incentive fees? And might the interests of a manager with 100% of his net worth in his fund have diverged from the interests of LPs who invested 1% of theirs?

© Oaktree Capital Management, L.P. All Rights Reserved when problems surface. It’s instructive to note that a lot of CDO debt built on subprime mortgages received triple-A ratings, many of which already have required downward adjustment. And that rating agencies helped CDO managers design structures so they would receive the desired rating. And that managers would run a structure past a few agencies and hire the one that arrived at the highest rating. And that ratings are paid for by those sponsoring the securities being rated, something which sounds like a trial where the defendant picks and pays the judge. All of these paragraphs highlight errors made by investors this time around . . . of a type that always will be made (but with variations on the theme). The lesson isn’t to distrust managers, or models, or ratings, or diversification, or market efficiency. What investors must learn – but most will not – is that there’s no easy answer, surefire tool or silver bullet. Lots of tools will help when applied thoughtfully, but they’ll bring harm otherwise – with the additional risk that excessive reliance on them will increase the damage done when they turn out to be unavailing. Certainly none of the highly-touted things discussed above held the answer this time around. Only truly superior skill, discipline and integrity are likely to produce consistently high returns in the long run with limited risk.

© Oaktree Capital Management, L.P. All Rights Reserved were going well, one of Long-Term’s principals had said, “We’re going around the world scooping up nickels and dimes.” There’s great appeal to his notion of profiting from a large number of small mispricings that others aren’t smart enough to seize upon. But he had left off a few key words from the end of his sentence: “. . . in front of a steamroller.” The steamroller enters the picture when so much leverage is employed that a fund can’t survive a moment of aberrant market behavior. TIn a memo on hedge funds in October 2004, I mentioned that when there’s a big increase in the number of little fish attempting to live off each big fish’s leavings (or in the number of hedge funds relative to mainstream investors), the pickings become slimmer. Given the increased efforts to exploit inefficiencies today and the fact that strong cash inflows and resultant high prices have depressed prospective returns in many markets, managers are often resorting to increased leverage in order to reach their return targets. But it’s essential to remember that leverage is the ultimate two-edged sword: it doesn’t alter the probability of being right or wrong; it just magnifies the consequences of both. TUThe Perils of Diversification TThe Amaranth saga demonstrates that the riskiness of a portfolio is not just a function of the fundamental nature of its holdings, but also of things like concentration and leverage.

I often say there is no investment so good that it can’t be ruined by too-high an entry price. There’s also no investment so safe that can’t be rendered risky by buying too much of it with borrowed money. TDiversification has long been considered a pillar of conservative investing. It’s a simple concept: “Don’t put all your eggs in one basket.” Spreading your capital among a number of assets or strategies reduces the likelihood of a disaster. TIn the 1960s, Bill Sharpe pointed out that adding in a risky but uncorrelated asset can reduce a portfolio’s overall riskiness. It has become accepted wisdom that overall risk can be reduced (and return increased) by adding alternative investments to a portfolio of stocks and bonds. TBut people don’t always take note of a dangerous outgrowth of these dicta: that diversifying into uncorrelated assets with borrowed money can increase, not reduce, the risk of the portfolio. TLet’s say you have $100 invested in U.S. stocks. You realize how undiversified your portfolio is, and that a market crash can bring a substantial loss. So you sell off $75 worth of stocks and put $25 each into emerging market stocks, high yield bonds and natural gas futures. Now your portfolio is invested equally in four asset classes rather than one and thus probably safer. TBut what if, instead, you hold onto your $100 worth of U.S. stocks and borrow another $300, investing $100 in each of those three new asset classes.

© Oaktree Capital Management, L.P. All Rights Reserved TA crash that wipes out one of the four asset classes in the diversified $100 portfolio will reduce your net worth by 25%. But that same crash, when experienced in the leveraged and equally diversified $400 portfolio, will eliminate your entire net worth. So investors should always consider the combined effect of diversification and leverage. Amaranth was much safer when it was all in convertible arbitrage than after it increased its leverage in order to diversify into energy trading. Diversification is a good thing, but a lot depends on how you finance it. T“Multi-strategy” is one of today’s hot buzz words. But as Orin Kramer puts it (see page 12 for who he is), “Amaranth is a reminder that a multi-strategy structure is not a proxy for risk diversification.” That is, I think, multi-strategy + risk control = protective diversification, while multi-strategy + leverage = more ways to lose. UGenerating Alpha I want to say up front that I have absolutely no idea how one dependably achieves above average profits from trading or investing in commodities, precious metals or currencies. That’s not to say it can’t be done. There are people who’ve gotten very rich that way, managing both their own money and that of others.

© Oaktree Capital Management, L.P. All Rights Reserved 5BUSo Is It Risky Or Not? 6BCasual onlookers rarely see that as a tough question. But like most aspects of investing, the more obvious the answers seem, the less likely they are to be true. 7BMany considerations on the subject of risk are actually paradoxical. Investing requires us to deal with the future, and the difficulty of cracking the future is the source of most of the risk. The actual riskiness of many aspects of investing depends on the extent to which an investor is capable of knowing something about the future, or – perhaps better put – of knowing more than the average investor. 8BFor example, let’s consider diversification versus concentration. Is concentration risky? Not if you know what the future holds. Diversification by definition implies a willingness to trad off return for safety, motivated by acceptance of the fact that knowledge of the future is imperfect. Most investors rank their stocks by potential return, formally or informally, but no one I know buys just the one they expect to deliver the highest return. Why? Because they know their rankings might be wrong and don’t want to bet it all on black and see red come up. Concentration is risky for investors who can’t see the future with much clarity, but it wouldn’t be for one who can. For the latter, it’s the way to maximize performance, and diversification can hold it back. e What about illiquidity?

© Oaktree Capital Management, L.P. All Rights Reserved 11BUComplexity in Risk Assessment It is my purpose in this section to highlight a few reasons why risk assessment is not simply a matter of one number (as implied by the attention paid to volatility), but multi-dimensional instead. Rick Funston of Deloitte pointed out in our board briefing materials that risk assessment requires us to deal with four complicating factors:  Scenarios  Offsets  Correlations  Domino effects By “scenarios,” Rick refers to alternative or abnormal future scenarios that go beyond the normal range of outcomes – in his words, “the possible but unusual.” “Offsets” translate in the investment world into something very familiar: diversification. Intelligent diversification means not just investing in a bunch of different things, but in things that respond differently to the same factors. In a well-diversified portfolio, something that negatively influences investment A might have a positive and offsetting influence on investment B. “Correlations” are somewhat the opposite. The term refers to the chance that a number of investments will respond in the same way to a given factor. Be alert, however, to the fact that when things in the environment turn really negative, seemingly unconnected investments can be similarly affected. “In times of panic,” they say, “all correlations go to one.

Investment committee decisions can’t be improved by members possessing below average skill, experience and expertise. The bottom 50% of the universe may help by giving the top participants a manager median they can beat, but they do not contribute to the pursuit of superior results for themselves or those who employ them. Some investment organizations are egalitarian and democratic. Participation in the investment process is broad and diffuse. Everyone gets a little money to manage, or everyone gets a vote. This approach doesn’t appeal to me, because of my conviction that investment skill isn’t distributed evenly. Every team includes some members who are more skilled than others. It is they who should have greater influence in the decision making process. It’s nice to see the junior members developed as professionals and given valuable experience, but bringing more people into the process doesn’t necessarily enhance performance in the short run. I’ve watched an investment organization at work where the portfolio was divided up among several professionals, each of whom ran his portion separately. It seemed to me that each one engaged in individual stock-picking; no one was responsible for considering the portfolio’s overall diversification and risk; and, in fact, each person relied (without justification) on the others to balance out the extremeness of his actions.

In small markets, everyone may know about your trades. That means they can copy them (making buying tough and adding to the crowd that will eventually jam the exits), and they can deny you fair prices if they know you have to sell. Aggressive traders, especially at hedge funds, don’t wear kid gloves.  Underestimating correlation. There’s another old saying: “In times of crisis, all correlations go to one.” It means that assets with no fundamental or economic connection can be caused by market conditions to move in lockstep. If a hedge fund experiences heavy withdrawals during a period of illiquidity, assets of various types may have to be dumped at once, and thus they can all decline together. Further, hidden fault lines in portfolios can produce unexpected co-movement. Let’s say you’re long sugar and gas, two unrelated commodities. Unusually warm weather can reduce the demand for gas for heating and also cause a record sugar crop (as happened this year). Thus the prices of seemingly unrelated goods can decline together. Intelligent diversification doesn’t mean just owning different things; it means owning things that will respond differently to a given set of environmental factors. Thus it requires a thorough understanding of potential connections. The case of Amaranth is highly and painfully instructive, and it bears out another of my favorite expressions: Experience is what you got when you didn’t get what you wanted.

As you know, a year ago we sold roughly 6% of the firm to seven long-term clients at its fair market value. Our objectives were achieved: personal diversification, of course, but – more importantly – demonstration, by posting a real-world price, that the 60 non-Principal owners had done well and been treated fairly. It’s working entirely as we had hoped: the new investors are constructive but not intrusive. What could be better? Doubtless you will see further sales of ownership to third parties over time, but never transferring control. And of course ownership among employees will be broadened further. In short, we like the idea of working together, but not of working for someone else. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Well that’s the way I’ve always thought of the investment world. Mainstream institutional investors emphasize the big asset classes and follow the big companies, creating a relatively efficient market and a context for relative valuation. But their attention wanes as the targets shrink, and their hands are tied by constraints on their behavior. Little guys such as hedge funds operate in the interstices. They take advantage of small inefficiencies and misvaluations that the big guys create, permit or ignore. They pursue things that are unseemly, esoteric or highly labor intensive. And they can employ tactics like leverage and shorting – and live with levels of portfolio concentration and illiquidity – that aren’t tolerated in the mainstream investment world. In other words they, too, benefit from the big guys’ leavings. The critical question is obvious: How many little fish can thrive in the shadow of each big fish? A hundred little fish trailing each big one all can do well. But those crumbs won’t feed five hundred. Not only will the crumbs be insufficient in number, but the crowd will fight over them in a way that’s unhealthy for everyone. Tortured enough? Maybe so, but I think the analogy holds. In my time in this business, the institutions have been the big fish of the investment world, and the hedge funds and alternative investment specialists have profited from their biases and limitations.

© Oaktree Capital Management, L.P. All Rights Reserved Oaktree follows a clearly defined route that it trusts will bring investment success: If we avoid the losers, the winners will take care of themselves. We think the most dependable way for us to generate the performance our clients seek is by avoiding losing investments. We don’t claim that this is the only way to invest well; others may choose more aggressive approaches, and they may work for them. This is the way for us. Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate. You may hit fewer home runs than another investor . . . but you’re also likely to have fewer strikeouts and fewer inning-ending double plays. The ingredients in defensive investing include (a) insistence on solid, identifiable value at a bargain price, (b) diversification rather than concentration, and (c) avoidance of reliance on macro-forecasts and market timing. Warren Buffett constantly stresses “margin of safety.” In other words, you shouldn’t pay prices so high that they presuppose (and are reliant on) things going right. Instead, prices should be so low that you can profit – or at least avoid loss – even if things go wrong. Purchase prices below intrinsic value will, in and of themselves, result in larger gains, smaller losses, and easier exits. “Defensive investing” sounds very erudite, but I can simplify it: Invest scared!

Because so few stocks are bought today for asset values, we essentially can disregard them. The vast majority of stocks are bought for the stream of earnings the companies produce. But how do those earnings affect investors – get through to investors – if not in the form of dividends? That's the question that drove me in the 1960s. It almost verges on metaphysical. If a company has great earnings but those earnings aren't ever paid out in dividends, are they still of value to investors? If it makes a bunch of money but just hoards it, or reinvests it in new products and facilities that generate future earnings that also are not paid out, in what way are its profits of value to investors? That's kind of like the old question, "if a tree falls in the forest but there's no one around to hear it, does it still make noise?" There are two possible answers:  Eventually, earnings must be paid out. Common sense tells us that, sooner or later, every company will run out of good reinvestment opportunities, and the cash will then go to dividends, or to stock buy-backs, which have the same effect but better tax treatment. (Of course, the record suggests that when they run out of good reinvestment opportunities, companies often prefer bad reinvestment opportunities to giving the money to the shareholders.)

© Oaktree Capital Management, L.P. All Rights Reserved . . . but there's something of an oxymoron afoot. Even though thousands of people expect to make a living from active investment management, much of traditional investment thinking is built on the realization that alpha is severely limited (even though the practitioners don't state it that way). Why do I say that? Most investors claim they can outperform the market – that is, can see, assess and understand better than the average investor – because of superior intelligence and hard work. Doesn't everyone think he can beat the market? But much of what's actually practiced, even by Oaktree, subtly acknowledges that the ability to know more – and if you think of it, that's a lot of what alpha really is – is quite limited. It's a common assumption that if an investor's portfolios are highly concentrated, they're risky. But that assumes he can't see the future. If he could, it would be perfectly safe to have a low level of diversification. In fact, if his foresight were perfect, then the safest portfolio would hold only one asset, because that's the one he would think of most highly (and, since he could see the future, he would of course be right). Thus diversification, which is widely practiced even in the "I know" school of investing, represents a tacit acknowledgement that there's a lot that investors don't know. Investors' strong preference for liquidity is another indicator that this limitation is accepted.

The truth is, there's no place for them to go but up and down . . . and so they do. Likewise, there are business trends that have nowhere to go but back and forth . . . and so they do. Take corporate diversification, for example. As a new equity analyst in 1970, one of my first assignments was to study conglomerates, starting with Litton, ITT, Whittaker, Teledyne and City Investing. It was widely held that their diversification and synergies (along with the magic of acquisition accounting and high p/e "funny money") could produce rapid growth forever. They pursued large numbers of acquisitions (ITT made 52 one year) and were rewarded with very high p/e ratios (which enabled them to prolong their growth for a while through further anti-dilutive acquisitions). It wasn't long, however, before their dependence on sky-high multiples was recognized and difficulties surfaced in connection with the management of their diverse organizations. Their managers switched to stressing the benefits of specialization (as opposed to diversification), and the head of Whittaker wrote a paper extolling the virtues of a process he called "distillation of the product centroid." Units began to be sold off and the companies deconglomerated. It's interesting to note that none of those five companies exists today. Diversification or specialization? Centralization or decentralization? Savings through just-in-time inventories or protection from stockpiles and redundancy?

© Oaktree Capital Management, L.P. All Rights Reserved Most pension funds have a very long time horizon, and for a university endowment it's theoretically infinite. Volatile quarterly returns wouldn't be a meaningful source of risk for them as they would be for a retiree scraping by. But once you say a given portfolio is risky for one investor but not another, there ceases to be a unique number that measures its absolute riskiness. In that case, how can you talk about its risk, or its risk-adjusted return? UCorrelationU – The final analytical element to be considered when assembling securities into portfolios is their degree of connectedness, or correlation. As discussed above, a one-asset portfolio would be optimal for someone who can see the future. The main reason for holding more than one asset is diversification. But the principal virtue of diversification, protection from catastrophic error, is wiped out if the underlying assets will react the same to environmental change and move together. Thus it's not enough to be able to estimate return and risk in isolation; we must understand correlation. Even if we can estimate the separate potential of two assets, we cannot know how a portfolio combining them will behave unless we know how they will move relative to each other. Two stocks in the same industry may be highly correlated, but two companies whose products compete directly may not (that is, whichever one wins, the other is likely to lose).

© Oaktree Capital Management, L.P. All Rights Reserved  “One of the most troubling aspects of a market crisis is that diversification strategies fail. Assets that are uncorrelated suddenly become highly correlated, and all positions go down together. The reason for the lack of diversification is that in a [volatile] market, all assets in fact are the same. The factors that differentiate them in normal times are no longer relevant. What matters is no longer the economic or financial relationship between assets but the degree to which they share habitat. What matters is who holds the assets.” In recent years, the “habitat” in which most investors feel comfortable has expanded. Barriers to entry have fallen, access to information has increased and, perhaps most importantly, most investors' forays abroad have been rewarded. Thus “market participants become more like one another, which means that liquidity demanders all [hold] pretty much the same assets and grab whatever sources of liquidity are available.” If they are held by the same-traders, “two types of unrelated-assets will become highly correlated because a loss in the one asset will force the traders to liquidate the other.” That's not a bad explanation for the fact that when Long-Term Capital and the emerging markets crashed in September 1998, high yield bonds and other unrelated asset classes fell with them.

I hope you'll recognize in the above some of the elements behind the Oaktree approach, as exemplified by our work with distressed debt.  We look for Bookstaber's “liquidity demanders,” with their exogenous motivations. We call them forced sellers, and they provide our best bargains.  We take advantage when “noneconomic” market conditions increase the pressure to sell even as asset prices move lower.  And we rarely approach holders to buy, preferring to wait until they call us. In that way we are “liquidity suppliers” rather than eager buyers. Take it from me, the latter pay more. Many of us may have had thoughts like Bookstaber's, and in my 30+ years in money management I've had plenty of chances to watch liquidity demand soar, liquidity supply dry up, prices collapse and diversification fail. But I respect someone who can put into a rigorous framework that which “everybody knows.” Speaking of panics, we all recognize the carnage that occurs when the desire to sell far exceeds the willingness to buy. But I think Bookstaber's analysis applies equally to the opposite - times when the desire to buy outstrips the willingness to sell. It's called a buying panic and represents no less of a crisis, even though - because the immediate result is profit rather than loss - it is discussed in different terms. Certainly 1999 was just as much of an irrational, liquidity-driven crisis as 1987.

© Oaktree Capital Management, L.P. All Rights Reserved P.s.: The apocalyptic view of the current situation states that the world economy is dependent on the prosperity of the United States; the prosperity of the United States is based on the health of its stock market; the performance of the stock market is being driven by gains in a relatively small number of tech, Internet and telecommunications stocks; and therefore, when the inevitable correction comes in those few stocks, the ramifications will be worldwide. No one knows the extent to which this hypothesis will be proved correct. The column below, from The New York Times of January 1, 2000, presents a more benign and enjoyable view.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: How's the Market? April 5 was just another ordinary day in the market, with big gains achieved and records broken. The Wall Street Journal article about it on April 6 was ordinary too, like hundreds that have been written in this bull market. I was struck, though, by the way it told in just a few paragraphs the whole story of what's been going on. UJust another dayU - On the surface, the aggregate stock market numbers continued to be very positive, with the Dow up 175 points, or 1.8%, to a new record. The S&P 500 was up 2.1% and the Nasdaq Composite Index was up 2.7%. Even on this day of huge aggregate gains, however, participation was still relatively narrow. Almost as many stocks were down (1,318) as up (1,695). Moreover, more stocks set new 52-week lows (81) than set new highs (73). This reminded me about the reliance of the market on just a few issues: In the first quarter of this year, 18 stocks accounted for Uall Uof the 5% rise in the S&P 500, (that's right, the other 482 stocks averaged a zero return). 55% of the stocks in the S&P lost money, and the Russell 2000 index of second tier stocks Udeclined U5.4%. UFollow the leaderU -- So the leadership continued to be concentrated, as everyone knows, in just a few stocks. Yahoo gained 22% on the day, and Amazon.com was up 9%.

© Oaktree Capital Management, L.P. All Rights Reserved The article goes on to cite the arguments behind this year's version of "this time it'll be different." First, because the recovery has been wishy-washy to date, there is no "boom" to "bust." Second, today's enhanced pace of business has been accommodated more through flexibility and efficiency than through brick-and-mortar expansion and inventory building. Third, the service economy has largely supplanted the more cyclical manufacturing sector. Fourth, globalization of the economy will enhance geographic diversification and provide new sources of demand for goods. Similarly, we all hear lots of reasons why today's high stock market valuations aren't dangerous and no correction is required. These include the inevitability of 401(k) inflows; the steadfastness of mutual fund investors; the shortage of stocks which will result from corporate buybacks (in 1987, the shortage was going to result from the privatization of companies via leveraged buyouts); the vast opportunities presented by technology and the Internet; the improved profit stance of business after years of downsizing and cost-cutting; the fiscal responsibility imposed on government and the resulting favorable outlook for the deficit; and the irrelevance of dividend yield and other traditional valuation parameters. As always, the list appears to grow longer as higher levels are reached on the Dow.

© Oaktree Capital Management, L.P. All Rights Reserved 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." UInvestment actions predicated on everything continuing to go well are bound to failU. 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. - 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."

© Oaktree Capital Management, L.P. All Rights Reserved 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 well- received 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."