Howard Marks on Index Investing

© 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.

But Charlie Munger exhorts us to “invert,” or flip questions like this. To me, this means allocators should ask themselves, “What are the arguments for not putting a significant portion of our capital into credit today?” Here I’ll mention that, over the years, I’ve seen institutional investors pay lip service to developments in markets and make modest changes in their asset allocation in response. When the early index funds outperformed active management in the 1980s, they said, “We’ve got that covered: We’ve moved 2% of our equities to an index fund.” When emerging markets look attractive, the response is often to move another 2%. And from time to time, a client tells me they’ve put 2% in gold. But if the developments I describe really constitute a sea change as I believe – fundamental, significant, and potentially long- lasting – credit instruments should probably represent a substantial portion of portfolios . . . perhaps the majority. © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

” If markets are efficient and securities are always priced correctly, there can be no value in active investing. The truth is that many active managers, especially in developed market equities, have failed to demonstrate the ability to add value, or to add enough value to justify their management fees. This is largely why index funds were created and why a significant amount of equity capital has migrated to index and passive investing in recent decades. And yet, I firmly believe there are times when the markets are overpriced and times when they’re underpriced. There are also times when particular markets or sectors are overpriced or underpriced relative to others. In these instances, some securities can be priced too high or too low, and thus some positions on the risk curve can offer better bargains than others. The theory assumes investors are rational and objective, but psychological excesses violate that assumption. Take, for example, the investment environment during the Global Financial Crisis. As I described in my July memo Taking the Temperature, in late 2008, investors were so worried about a financial sector meltdown that they panicked and sold securities aggressively as their prices collapsed. Excessive risk aversion causes the risk/return line to steepen (increasing the return for each incremental unit of risk borne) and perhaps even to curve upward (rendering the compensation for making investments at the risky end of the spectrum disproportionately generous).

Most people buy stocks with the goal of selling them at a higher price, thinking they’re for trading, not for owning. This means they abandon the owner mentality and instead act like gamblers or speculators who bet on stock price moves. The results are often unpleasant. The DALBAR Institute 2012 study showed that investors receive three percentage points less per year than the S&P 500 generated from 1992 to 2012, and the average holding period for a typical investor is six months. Six Months!! When you hold a stock for less than a year, you are not using the stock market to acquire business ownership positions and participate in the growth of that business. Instead, you are just guessing at short-term news and expectations, and your returns are based on how other people react to that news information. In aggregate, that kind of attitude gets you three percentage points less per year than you’d get from doing nothing at all beyond making the initial investment in the index fund of the S&P 500. (“Fidelity’s Best Investors Are Dead,” The Conservative Income Investor, April 8, 2020) To me, buying for a short-term trade equates to forgetting about your sports team’s chances of winning the championship and instead betting on who’s going to succeed in the next play, period, or inning. Let’s think about the logic. You buy a stock because you think it’s worth more than you have to pay for it, whereas the seller considers it fully priced.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: powerful shift in recent decades toward indexing and other forms of passive investing has taken place for the simple reason that active investment decisions are so often wrong. Of course, many forms of error contribute to this reality. Whatever the reason, however, we have to conclude that, on average, active professional investors held more of the things that did less well and less of the things that outperformed, and/or that they bought too much at elevated prices and sold too much at depressed prices. Passive investing hasn’t grown to cover the majority of U.S. equity mutual fund capital because passive results have been so good; I think it’s because active management has been so bad. Back when I worked at First National City Bank 50 years ago, prospective clients used to ask, “What kind of return do you think you can make in an equity portfolio?” The standard answer was 12%. Why? “Well,” we said (so simplistically), “the stock market returns about 10% a year. A little effort should enable us to improve on that by at least 20%.” Of course, as time has shown, there’s no truth in that. “A little effort” didn’t add anything. In fact, in most cases, active investing detracted: most equity funds failed to keep up with the indices, especially after fees. What about the ultimate proof?

One of my favorite sayings came from a pit boss at a Las Vegas casino: “The more you bet, the more you win when you win.” Absolutely inarguable. But the pit boss conveniently omitted the converse: “The more you bet, the more you lose when you lose.” Clearly, those two ideas go together. In a presentation I occasionally make to institutional clients, I employ PowerPoint animation to graphically portray the essence of this situation: • A bubble drops down, containing the words “Try to be right.” That’s what active investing is all about. But then a few more words show up in the bubble: “Run the risk of being wrong.” The bottom line is that you simply can’t do the former without also doing the latter. They’re inextricably intertwined. • Then another bubble drops down, with the label “Can’t lose.” There are can’t-lose strategies in investing. If you buy T-bills, you can’t have a negative return. If you invest in an index fund, you can’t underperform the index. But then two more words appear in the second bubble: “Can’t win.” People who use can’t-lose strategies by necessity surrender the possibility of winning. T- bill investors can’t earn more than the lowest of yields. Index fund investors can’t outperform. • And that brings me to the assignment I imagine receiving from unenlightened clients: “Just apply the first set of words from each bubble: Try to outperform while employing can’t-lose strategies.” But that combination happens to be unavailable.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: cycle, however you want to define it. But there’s also change, and a lot of that takes place in the mechanical world: changes in information processing, changes in technological products, and so forth. PS: I’d like to talk more about the memo Investing Without People. You basically express your worry about mechanical investing, specifically passive investing. I’ll quote as follows: “When everyone decides to refrain from performing the functions of analysis, price discovery and asset allocation, the appropriateness of market prices can go out the window as a result of passive investing, just as it does from a mindless boom or bust.” Do you think mechanical investing could have a negative impact on informational efficiency because it only uses market internals like market cap, bid/ask, momentum, and, in a way, therefore distorts or ignores the transmission of information coming from the real economy?

And, as a consequence, if we look at a chain of discovery through the economic system – starting with a scientist having an insight, and then an inventor having an invention, and an entrepreneur making an innovation, eventually ending up in financial markets valuing this stuff – when things become more and more mechanical through the growth of these strategies – which include high frequency trading, trend-following, smart beta, which you mentioned, and of course passive investing – we run the risk that the separation between Mr. Market and the real economy just increases … that, in other words, this chain becomes more vulnerable and can break? HM: You know, Patrick, I think the flaw in passive investing lies in the fact that you have to view passive investing – things like indexation, especially – as kind of a hitchhiker, a free-rider on the market. In other words, there are 1,000 people out here doing active investing and distilling all the information and thinking about the future of the company and thinking about the fairness of the price, and the result is a market price. And, as I said before, that price is the best everybody collectively can do in trying to value the company and its future. And then there are ten people over there who run index funds, and they just buy at the market prices because they think those prices are probably fair, or the best you can do, so why go to all the trouble and expense of doing fundamental analysis?

[The managers of passive funds feel no need to independently think about company fundamentals or the fairness of price. They take the active investors’ word for it.] So, that’s why I say, “free-rider.” The ten free-ride on the efforts of the 1,000. But what happens if the number of people doing fundamental analysis – active investing – declines from 1,000 to 500 to 100 to 50 to 10? Now you have 1,000 people free-riding on the efforts of the ten. The potential for divergence between price and fair price increases, and free- riding is not as easy to do or as risk-free. I think the irony, as I said in that memo, Investing Without People, is that active investing is no good; passive investing works better, but only if people keep doing active investing. You mentioned conundrums. This is a conundrum: the less people invest actively, the greater scope there is for price to diverge from value. In theory, it becomes easier to find bargains and overpriced securities, and the return from active effort rises. So that’s the irony. And, the other thing is, we have to bear in mind that, let’s say everybody at this conference stipulated that over the next ten years, every dollar that went into the stock market would go into the S&P 500, perhaps through index funds or ETFs. Clearly, the prices of the S&P 500 stocks would rise, maybe more than they should, and everything else would languish.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: relative to the things inside the index that they have to begin to do better, at which point active investing outperforms and maybe a few people at the margin give up on passive. So it’s kind of reflexive. I take reflexivity to mean that the actions of the participants change the formula for success, and that’s what we could be talking about here. PS: But if we come back to the chain of discovery, if this growing mechanization has an impact on the transmission and allocation of capital at the core of where people innovate, then that clearly is detrimental for society. To put it controversially, but acknowledging this risk, should passive investing be charged for its free-riding and subsidize the extra costs of active investing? HM: The only way to do that, of course, would be to keep the prices of assets secret and charge people for admission to that room, but I don’t think that’s ever going to happen. In the memo Investing Without People, there are three sections. The first is passive and index, which is here now in a big way. The second is algorithmic and systematic, which is here in a small way. And the third is AI and machine learning, which is really – for investing – not here yet. We know what’s happened with passive investing, because it has outperformed active [and now is employed to manage a substantial portion of equity investments].

This discussion is based on material I included in my 2018 book Mastering the Market Cycle: Getting the Odds on Your Side. While I may appear to be talking about one good year and one bad one, these observations can only be considered valid if these patterns hold over a meaningful number of years. Let’s consider a manager’s performance: Market performance +10% -10% Manager A +10% -10% The above manager clearly adds no value. You might as well invest in an index fund (probably at a much lower fee). These two managers also add no value: Market performance +10% -10% Manager B +5% -5% Manager C +20% -20% Manager B is just a no-alpha manager with a beta of 0.5, and manager C is a no-alpha manager with a beta of 2.0. You could get the same results as manager B by putting half your capital in an index fund and keeping the rest under your mattress and in the case of manager C, by doubling your investment with borrowed capital and putting it all in an index fund. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: How Is Investing Like Gambling? Hidden information, luck and skill can play a part in investing. In active investing involving public companies, for example, all three are involved.  Clearly, no one knows all the relevant facts. The SEC tries to make sure all investors have equal access to information, but not necessarily complete access. For example, investors won’t know about first-quarter developments at a company until it reports earnings in May. And no one is supposed to know the results of drug trials and beta tests until they’re made public.  Luck – random, unpredictable, often-exogenous events – affects companies and their stocks all the time. Many aspects of corporate performance and profitability can be influenced by weather, for example. And the TV network carrying the World Series is likely to enjoy much greater ad revenue if the teams playing come from major markets rather than small ones.  Finally, the superior investor has the skill required to better assess revenue and profit potential, where we stand in the cycle, the fairness of an asset’s price and the margin of safety it affords. No one gets these things right all the time, but the superior investor does so more often than most. Not all investing, however, entails all – or necessarily any – of the three elements. Take, for example, index investing. The index fund manager’s job is to produce the same return as the relevant index.

 There’s no such thing as hidden information. The only information the investor needs to succeed at his job relates to the composition of the index in question, and there’s no mystery in that regard.  Likewise, there’s no luck. The forces that influence the securities in the index will have exactly the same influence on a properly constructed index fund.  And finally, there’s no skill. All it takes is a well-programmed computer to keep the fund’s portfolio in line with the index, and that isn’t hard to find. It’s worth delving into the matter of investing skill. The efficient market hypothesis posits that (a) markets are “efficient,” (b) thus assets are priced fairly and there are no bargains or overpriced assets, and (c) as a result, there’s no scope for skill or “alpha,” defined as the ability to outperform by capitalizing on mispricings. The traditional view of active investing, which ignores this hypothesis, is that investing is like blackjack, meaning it’s possible for some people to be better at it than others. But if the efficient market hypothesis is right, investing is like roulette, with investors’ returns beyond their control and solely a function of luck, or what the market does. (Of course, a portfolio’s return can be amplified or diminished relative to the market’s return by the portfolio’s relative sensitivity to it: the “beta.” And that leads to the question of whether investors have the skill to move beta up and down in a timely fashion.)

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: it’s not – and the portfolio return is mostly a function of the market’s return and the portfolio’s sensitivity to market movements – they’re called “beta” markets. Obviously it’s important to figure out which type of market you’re working in. For years, people (whether consciously or not) treated the stock market as an “alpha” market, and equity portfolio managers were able to charge substantial management fees for their efforts. But over time, it was increasingly observed that most active investors were incapable of consistently outperforming the market indices (especially after fees). That meant skill was lacking: you could get the same result or better by passively emulating an index. Investors concluded that they would no longer pay for alpha in a beta market, and that’s the main reason for the growth of passive investing. Why pay someone to play for you in a game where there’s no such thing as skill? What’s the bottom line? In my view, the active investing I’m interested in – hopefully in markets that are less efficient – involves all three of the ingredients under discussion: hidden information, luck and skill. Thus it’s most like poker and blackjack, not chess. It’s in that vein that I’ll proceed. The Essence One of the most important aspects of skill in gambling consists of figuring out which possible outcome to bet on, and when to bet heavily and when not to.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Investing Without People Over the last twelve months I’ve devoted three memos to discussing macro developments, market outlook, and recommendations for investor behavior. These are important topics, but usually not the ones that interest me most; I prefer to discuss things that are likely to affect the functioning of markets for years to come. Since little in the environment has changed from what I described in those three memos, I feel I now have the liberty to turn to some bigger-picture issues. This memo covers three ways in which securities markets seem to be moving toward reducing the role of people: (a) index investing and other forms of passive investing, (b) quantitative and algorithmic investing, and (c) artificial intelligence and machine learning. Before diving in, I want to state loud and clear that I don’t claim to be an expert on these subjects. I’ve watched the first for decades; I’ve recently learned a little about the second; and I’m trying to catch up regarding the third. On the other hand, since many of the “experts” in these fields are involved in them, I think they may be biased favorably toward them as potential successors to traditional active investing. What follow are just my opinions; as always you should make of them what you wish.

Passive Investing and ETFs I’ve told this story many times, but I want to repeat it here to lay a foundation for what follows. I arrived at the University of Chicago Graduate School of Business (not yet the Booth School) just over 50 years ago, in September 1967. The “Chicago school” of finance and investment theory – largely developed there in the early ’60s – had just begun to be taught. It was methodically constructed on theoretical underpinnings, as well as on a healthy dose of skepticism regarding what investors had been doing previously. One of the major foundational components was the “Efficient Market Hypothesis” and its conclusion that “you can’t beat the market.” First there was the logical argument: it seemed obvious that collectively all investors have to do average before fees and expenses, and thus below average after. And then there was the empirical evidence that for decades most mutual funds had performed behind stock indices like the Standard & Poor’s 500. My professors’ response in the late 1960s was simple, albeit hypothetical and fanciful: why not just buy shares in every company in an index? Doing so would allow investors to avoid the mistakes most people made, as well as the vast majority of the fees and costs associated with their efforts. And at least they would be assured of performing in line with the index, not behind it.

As far as I know, no one invested that way at the time and there were no publicly available vehicles for doing so: no “index funds” and no “passive investing.” I don’t think the terms even existed. But the © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: logic was clear and convincing, per the following citation from Wikipedia (with apologies to Richard Masson, my conscience regarding sources, for relying on it): In 1973, Burton Malkiel wrote A Random Walk Down Wall Street, which presented academic findings for the lay public. It was becoming well known in the lay financial press that most mutual funds were not beating the market indices. Malkiel wrote: What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out “You can’t buy the averages.” It’s time the public could. . . . there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis. . . . Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will. (Emphasis added) The first index fund appeared around that time. Again according to Wikipedia, the registration statement for the Qualidex Fund, designed to track the Dow Jones Industrial Average, became effective in 1972. I have no reason to believe it attracted many investors.

But then Jack Bogle formed the Vanguard Group in 1974, and Vanguard’s First Index Investment Trust went operational on the last day of 1975. At the time, it was heavily derided by competitors as being “un-American” and the fund itself was seen as “Bogle’s folly.” Fidelity Investments Chairman Edward Johnson was quoted as saying that he “[couldn’t] believe that the great mass of investors are going to be satisfied with receiving just average returns.” Bogle’s fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard & Poor’s 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999. (Wikipedia) The merits of index investing are obvious: vastly reduced management fees, minimal trading and related market impact and expenses, and the avoidance of human error. Thus index investing is a “can’t lose” strategy: you can’t fail to keep up with the index. Of course it’s also a “can’t win” strategy, since you also can’t beat the index (the two tend to go together). Index or passive investing got off to a relatively slow start. In the early years, I feel it was treated as a bit of an oddity or sideline: perhaps a candidate to take the place of one or two of an institutional investor’s active managers.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: institutions if any made passive investing a substantial part of their portfolios: thus it added a little spice but wasn’t a main dish. The empirical evidence of assets continuing to flow to passive management suggests that many active managers are still falling short of the indices. There have been lots of years in the last dozen in which the shortfall has been pronounced, and I’m not aware of many that were the reverse. As a result, the trend toward passive investing has steadily gained momentum (e.g., the Vanguard 500 Index Fund now stands at $410 billion). According to data from Morningstar, roughly similar amounts went into active and passive equity mutual funds from 2005 through 2011, but the flows into passive funds accelerated in 2012, while the inflows to active funds began to decline and, in 2015, turned into outflows. According to the Los Angeles Times, April 9, 2017: Conventional U.S. stock mutual funds that invest passively now hold $1.9 trillion in assets, triple what they had in 2007. Add in the $1.7 trillion in U.S. equity exchange- traded funds, another type of index portfolio, and the total in passive funds accounts for 42% of all U.S. stock fund assets — up dramatically from 24% in 2010 and just 12% in 2000. These figures apply mostly to “retail” investments, leaving out institutional portfolios where passive investing also has grown dramatically.

Rather than being an exotic add-on with a few percent of a portfolio’s assets, passive investing is now mainstream among institutions, perhaps often accounting for 20% or so of total assets. Given the L.A. Times quote above, I want now to introduce ETFs, or exchange-traded funds. In the 1990s, money managers came up with a new way to offer participation in the markets, in competition with index mutual funds. Whereas investors can only invest in or redeem from mutual funds at the close of trading each day, when the daily closing net asset value (or NAV) is calculated, ETFs can be bought or sold like company shares anytime exchanges are open. The ability to transact much more freely has attracted a lot of attention to ETFs. And while index ETFs gave this new field its start and still represent the vast bulk of ETFs, there are many other types these days. In the late 20th century, “index investing” and “passive investing” were synonymous: vehicles designed to passively emulate market indices. But now there’s a difference. Today this is called index investing. Passive investing has grown to include not just index funds and index ETFs, but also “smart-beta” ETFs that invest according to portfolio construction rules. Think of them as actively designed, rules-based vehicles. Once the rules are set, they’re followed without discretion. As I wrote a year ago: [To grow their businesses], ETF sponsors have been turning to “smarter,” not- exactly-passive vehicles.

Now I’m going to turn to the implications of passive investing and its increasing popularity. The first question is, “Is passive investing wise?” In passive investing, no one at the fund is studying companies, assessing their potential, or thinking about what stock price is justified. And no one’s making active decisions as to whether particular stocks should be included in a portfolio and, if so, how they should be weighted. They’re just emulating the index. Is it a good idea to invest with absolutely no regard for company fundamentals, security prices or portfolio weightings? Certainly not. But passive investing dispenses with this concern by counting on active investors to perform those functions. The key lies in remembering why it is that the Efficient Market Hypothesis says active management can’t work, and thus why it expects everyone (good or bad luck aside) to just end up with a return that’s fair for the risk borne . . . no more and no less. I touched on this in “There They Go Again . . . Again,” which will be the source for the next three citations: . . . the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced – that’s why there are no bargains to find. And where do the weightings of the stocks in indices come from? From the prices assigned to stocks by active investors.

In short, in the world view that gave rise to index and passive investing, active investors do the heavy lifting of security analysis and pricing, and passive investors freeload by holding portfolios determined entirely by the active investors’ decisions. There’s no such thing as a capitalization weighting to emulate in the absence of active investors’ efforts. The irony is that it’s active investors – so derided by the passive investing crowd – who set the prices that index investors pay for stocks and bonds, and thus who establish the market © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: capitalizations that determine the index weightings of securities that index funds emulate. If active investors are so devoid of insight, does it really make sense for passive investors to follow their dictates? And what happens if active investors quit doing that job? Thus the second question is, “What are the implications of passive investing for active investing?” If widespread active investing makes it impossible for active investing to succeed (by making markets too efficient and security prices too fair, per the Efficient Market Hypothesis), will the increasing prevalence of passive investing make active investing once again potentially profitable? . . . what happens when the majority of equity investment comes to be managed passively? Then prices will be freer to diverge from “fair,” and bargains (and over- pricings) should become more commonplace. This won’t assure success for active managers, but certainly it will satisfy a necessary condition for their efforts to be effective. How much of the investing that takes place has to be passive for price discovery to be insufficient to keep prices aligned with fair values? No one knows the answer to that. Right now about 40% of all equity mutual fund capital is invested passively, and the figure may be moving in that direction among institutions.

That’s probably not enough; most money is still managed actively, meaning a lot of price discovery is still taking place. Certainly 100% passive investing would suffice: can you picture a world in which nobody’s studying companies or assessing their stocks’ fair value? I’d gladly be the only investor working in that world. But where between 40% and 100% will prices begin to diverge enough from intrinsic values for active investing to be worthwhile? That’s the question. I don’t know, but we may find out . . . to the benefit of active investing. The third key question is: “Does passive and index investing distort stock prices?” This is an interesting question, answerable on several levels. The first level concerns the relative prices of the stocks in a capitalization-weighted index. People often ask whether inflows of capital into index funds cause the prices of the heaviest-weighted stocks in the index to rise relative to the rest. I think the answer is “no.” Suppose the market capitalizations of the stocks in a given index total $1 trillion. Suppose further that the capitalization of one popular stock in the index – perhaps one of the FAANGs – is $80 billion (8% of the total) and that of a smaller, less-adored one is $10 billion (1%). That means for every $100,000 in an index fund, $8,000 is in the former stock and $1,000 is in the latter. It further means that for every additional $100 that’s invested in the index, $8 will go into the former and $1 into the latter.

Thus the buying in the two stocks occasioned by inflows shouldn’t alter their relative pricing, since it represents the same percentage of their respective capitalizations. But that’s not the end of the story. The second level of analysis concerns stocks that are part of the indices versus those that aren’t. Clearly with passive investing on the rise, more capital will flow into index constituents than into other stocks, and capital may flow out of the stocks that aren’t in indices in order to flow into those that are. It seems obvious that this can cause the stocks in the indices to appreciate relative to non-index stocks for reasons other than fundamental ones. © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

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. The vast growth of ETFs and their popularity has coincided with the market rally that began roughly nine years ago. Thus we haven’t had a meaningful chance to see how they function on the downside. Might the inclusion and overweighting in ETFs of market darlings – a source of demand that may have driven up their prices – be a source of stronger-than-average selling pressure on the darlings during a retreat? Might it push down their prices more and cause investors to turn increasingly against them and against the ETFs that hold them? We won’t know until it happens, but it’s not hard to imagine the popularity that fueled the growth of ETFs in good times working to their disadvantage in bad times. Question number four: “Can the process of investing in indices be improved relative to simply buying the stocks in proportion to their market capitalizations, as the indices are constituted?” For many years my California-based friend Rob Arnott of Research Affiliates has argued for passive investing on the basis of fundamentally based indices as opposed to market-weighted indices. Rob is one of the real thinkers in our field, and I won’t try to recount his entire argument or do it justice.

A market is nothing more than the people in it and the decisions they make, and the behavior of those people shapes the market. When people invest more in certain stocks than others, the prices of those stocks rise in relative terms. And when everyone decides to refrain from performing the functions of analysis, price discovery and capital allocation, the appropriateness of market prices can go out the window (as a result of passive investing, just as it does in a mindless boom or bust). The bottom line is that the wisdom of investing passively depends, ironically, on some people investing actively. When active investing is dismissed totally and all active efforts cease, passive investing will become imprudent and opportunities for superior returns from active investing will reemerge. At least that’s the way I see it. Quantitative Investing My next topic – which, as I said, I’m just learning about (and thus I write with some trepidation) – goes by names such as quantitative, algorithmic and systematic investing. In this memo I’ll use the first of those. As I understand it, quantitative investing consists of establishing a set of rules (perhaps with help from a computer) and having a computer carry them out. There are at least two principal forms of quantitative investing. The first might be called “systematic factor investing.

It may be that AI and machine learning will someday permit computers to act as full participants in the markets, analyzing and reacting in real time to vast amounts of data with a level of judgment and insight equal to or better than many investors. But I doubt it will be anytime soon, and Soros’s Theory of Reflexivity reminds us that all those computers are likely to affect the market environment in ways that make it harder for them to achieve success. The Impact on Investing It’s only taken me until page fourteen to get to the issue that prompted me to start in on this memo: what these things imply for the future of our profession. For me, the situation regarding index and passive investing is clear:  Most people can’t and don’t beat the market, especially in markets that are more-efficient. On average, all portfolios’ returns are average before taking costs into account.  Active management introduces considerations such as management fees; commissions and market impact associated with trading; and the human error that often leads investors to buy and sell more at the wrong time than at the right time. These all have negative implications for net results.  The only aspect of active management with potential to offset the above negatives is alpha, or personal skill. However, relatively few people have much of it.  For this reason, large numbers of active managers fail to beat the market and justify their fees.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: It’s important to note that the trend toward passive investing hasn’t occurred because the returns there have been great. It’s because the results from active management have been poor, or at least not good enough to justify the fees charged. Now clients have wised up, and unless something changes with regard to the above, the trend toward passive investing is going to continue. What could arrest it?  More active managers could become capable of delivering alpha (but that’s not likely).  The markets could become easier to beat (that’ll probably happen from time to time).  Fees could come down so that they’re competitive with passive investment fees (but in that case it’s not clear how the active management infrastructure would be supported). Unless there are flaws in the above reasoning, the trend toward passive investing is likely to continue. At the very least, it reduces or eliminates management fees, trading costs, overtrading and human error: not a bad combination. Of course, there are active investors who outperform. Not most, and not half. But there’s a minority who do earn their fees, and they should continue to be in demand. * * * Moving on to quantitative investing, it’s particularly interesting to assess the future.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Thanks to the people who took the time to educate me, I’m a little less of a dinosaur regarding Bitcoin than I was when I wrote my last memo. I think I understand what a digital currency is, how Bitcoin works, and some of the arguments for it. But I still don’t feel like putting my money into it, because I consider it a speculative bubble. I’m willing to be proved wrong. Passive Investing Passive investing can be thought of as a low-risk, low-cost and non-opinionated way to participate in “the market,” and that view is making it more and more popular. But I continue to think about the impact of passive investing on the market. One of the most important things to always bear in mind is George Soros’s “theory of reflexivity,” which I paraphrase as saying that the efforts of investors to master the market affect the market they’re trying to master. In other words, how would golf be if the course played back: if the efforts of golfers to put their shot in the right place caused the right place to become the wrong place? That’s certainly the case with investing. It’s tempting to think of the investment environment as an unchanging backdrop, that is, an independent variable. Then all you have to do is figure out the right course of action and take it. But what if the environment is a dependent variable? Does the behavior of investors alter the environment in which they work? Of course it does.

The early foundation for passive or index investing lay in the belief that the efforts of active investors cause stocks to be priced fairly, so that they offer a fair risk-adjusted return. This “efficiency” makes it hard for mispricings to exist and for investors to identify them. “The average investor does average before fees,” I was taught, “and thus below average after fees. You might as well throw darts.” There’s less talk of dart-throwing these days, but much more money is being invested passively. If you want an index’s performance and believe active managers can’t deliver it (or beat it) after their high fees, why not just buy a little of every stock in the index? That way you’ll invest in the stocks in the index in proportion to their representation, which is presumed to be “right” since it is set by investors assessing their fundamentals. (Of course there’s a contradiction in this. Active managers have been judged to be unable to beat the market but competent to set appropriate market weightings for the passive investors to rely on. But why quibble?) The trend toward passive investing has made great strides. Roughly 35% of all U.S. equity investing is estimated to be done on a passive basis today, leaving 65% for active management.

Passive Investing/ETFs Fifty years ago, shortly after arriving at the University of Chicago for graduate school, I was taught that thanks to market efficiency, (a) assets are priced to provide fair risk-adjusted returns and (b) no one can consistently find the exceptions. In other words, “you can’t beat the market.” Our professors even advanced the idea of buying a little bit of each stock as a can’t-fail, low-cost way to outperform the stock-pickers. John Bogle put that suggestion into practice. Having founded Vanguard a year earlier, he launched the First Index Investment Trust in 1975, the first index fund to reach commercial scale. As a vehicle designed to emulate the S&P 500, it was later renamed the Vanguard 500 Index Fund. The concept of indexation, or passive investing, grew gradually over the next four decades, until it accounted for 20% of equity mutual fund assets in 2014. Given the generally lagging performance of active managers over the last dozen or so years, as well as the creation of ETFs, or exchange-traded funds, which make transacting simpler, the shift from active to passive investing has accelerated. Today it’s a powerful movement that has expanded to cover 37% of equity fund assets. In the last ten years, $1.4 trillion has flowed into index mutual funds and ETFs (and $1.2 trillion out of actively managed mutual funds).

However, Raj Mahajan of Goldman Sachs estimates that already a substantial majority of daily trading is originated by quantitative and systematic strategies including passive vehicles, quantitative/algorithmic funds and electronic market makers. In other words, just a fraction of trades have what Raj calls “originating decision makers” that are human beings making fundamental value judgments regarding companies and their stocks, and performing “price discovery” (that is, implementing their views of what something’s worth through discretionary purchases and sales). What percentage of assets has to be actively managed by investors driven by fundamentals and value for stocks to be priced “right,” market weightings to be reasonable and passive investing to be sensible? I don’t think there’s a way to know, but people say it can be as little as 20%. If that’s true, active, fundamentally driven investing will determine stock prices for a long time to come. But what if it takes more? © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Like all investment fashions, passive investing is being warmly embraced for its positives:  Passive portfolios have outperformed active investing over the last decade or so.  With passive investing you’re guaranteed not to underperform the index.  Finally, the much lower fees and expenses on passive vehicles are certain to constitute a permanent advantage relative to active management. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Does that mean passive investing, index funds and ETFs are a no-lose proposition? Certainly not:  While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming.  The recent underperformance on the part of active investors may well prove to be cyclical rather than permanent.  As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds. Here are a few more things worth thinking about: Remember, the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced – that’s why there are no bargains to find. But what happens when the majority of equity investment comes to be managed passively? Then prices will be freer to diverge from “fair,” and bargains (and over-pricings) should become more commonplace. This won’t assure success for active managers, but certainly it will satisfy a necessary condition for their efforts to be effective. One of my clients, the chief investment officer of a pension fund, told me the treasurer had proposed dumping all active managers and putting the whole fund into index funds and ETFs. My response was simple: ask him how much of the fund he’s comfortable having in assets no one is analyzing.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Passive investing is done in vehicles that make no judgments about the soundness of companies and the fairness of prices. More than $1 billion is flowing daily to “passive managers” (there’s an oxymoron for you) who buy regardless of price. I’ve always viewed index funds as “freeloaders” who make use of the consensus decisions of active investors for free. How comfortable can investors be these days, now that fewer and fewer active decisions are being made? Certainly the process described above can introduce distortions. At the simplest level, if all equity capital flows into index funds for their dependability and low cost, then the stocks in the indices will be expensive relative to those outside them. That will create widespread opportunities for active managers to find bargains among the latter. Today, with the proliferation of ETFs and their emphasis on the scalable market leaders, the FAANGs are a good example of insiders that are flying high, at least partially on the strength of non-discretionary buying. I’m not saying the passive investing process is faulty, just that it deserves more scrutiny than it’s getting today. The State of the Market There has been a lot of discussion about how elevated I think the market is. I’ve pushed back strongly against people who describe me as “super-bearish.

As Steven Bregman of Horizon Kinetics puts it, “basket-based mechanistic investing” is blindly moving trillions of dollars. ETFs don’t have fundamental analysts, and because they don’t question valuations, they don’t contribute to price discovery. Not only is the number of active managers’ analysts likely to decline if more money is shifted to passive investing, but people should also wonder about who’s setting the rules that govern passive funds’ portfolio construction. The low fees and expenses that make passive investments attractive mean their organizers have to emphasize scale. To earn higher fees than index funds and achieve profitable scale, ETF sponsors have been turning to “smarter,” not-exactly-passive vehicles. Thus ETFs have been organized to meet (or create) demand for funds in specialized areas such as various stock categories (value or growth), stock characteristics (low volatility or high quality), types of companies, or geographies. There are passive ETFs for people who want growth, value, high quality, low volatility and momentum. Going to the extreme, investors now can choose from funds that invest passively in companies that have gender-diverse senior management, practice “biblically responsible investing,” or focus on medical marijuana, solutions to obesity, serving millennials, and whiskey and spirits. But what does “passive” mean when a vehicle’s focus is so narrowly defined?

© 2015 Oaktree Capital Management, L.P. All Rights Reserved observation that the average investor’s return equals the market average. He, too, might as well flip a coin . . . or invest in an index fund. And by the way, the average participant’s average result – in both fields – is before transaction costs and fees. After costs, the average investor’s return is below that of the market. In that same vein, after costs the average football bettor doesn’t break even. What costs? In sports betting, we’re not talking about management fees or brokerage commissions, but “vigorish” or “the vig.” Wikipedia says it’s “also known as juice, the cut or the take . . . the amount charged by a bookmaker . . . for taking a bet from a gambler.” This obscure term refers to the fact that to try to win $10 from a bookie, you have to put up $11. You’re paid $10 if you win, but you’re out $11 if you lose. N.b.: bookies and sports betting parlors aren’t in business to provide a public service. If you bet against a friend and win half the time, you end up even. But if you bet against a bookie or a betting parlor and win half the time, on average you lose 10% of the amount wagered on every other bet. So at $10 per game, a bettor following the Post’s football helpers through December 28, 2014 would have won $13,280 on the 1,328 correct picks but lost $14,069 on the 1,279 losers. Overall, he would have lost $789 even though slightly more than half the picks were right.

© Oaktree Capital Management, L.P. All Rights Reserved Why should superior profits be available to the novice, the untutored or the lazy? Why should people be able to make above average returns without hard work and above average skill, and without knowing something most others don’t know? And yet many individuals invest based on the belief that they can. (If they didn’t believe that, wouldn’t they index or, at a minimum, turn over the task to others?) No, the solution can’t lie in rigid tactics, publicly available formulas or loss-eliminating rules . . . or in complete risk avoidance. Superior investment results can only stem from a better-than-average ability to figure out when risk taking will lead to gain and when it will end in loss. There is no alternative. Superior skill is an essential ingredient if superior investment results are to be achieved reliably. No tactic or technique will lead to superior results in the absence of superior judgment and implementation. But by definition, only a small percentage of investors possess superior skill. It is mathematically irrefutable that (a) the average investor will produce before-fee performance in line with the market average and (b) active management fees will pull the average investor’s return below the market average. This has to be considered in light of the fact that average performance can generally be obtained through passive investing, with tiny fees and almost no risk of falling short.

© Oaktree Capital Management, L.P. All Rights Reserved Based on data contained in Morningstar’s excellent report, the results in this regard are not encouraging:  Of the 15,774 funds tracked by Morningstar, 9,981, or 63%, charge 12b-1 fees.  Of 4,556 12b-1 funds for which there is at least five years of data on expense ratios, 66.2% showed an increase in the expense ratio over the last five years.  The percentage of funds showing expense ratio increases was roughly the same in 12b-1 funds as in non-12b-1 funds, but the average increase for the 12b-1 funds was slightly greater than for the non-12b-1 funds.  When looked at for nine years, the comparison is more negative. 12b-1 funds showed expense ratio increases more often than non-12b-1 funds, and the differential between the increases in the two groups was more unfavorable. As Morningstar puts it, “The above data strongly suggest that 12b-1 fees do not help funds materially reduce their expense ratios over time any more than would otherwise be the case, and may, in fact, do the opposite.” The fund companies have successfully transferred some of the costs of distribution to the funds’ investors, using 12b-1 fees primarily to pay brokers in order to increase assets and benefit the fund companies. But there is no evidence – certainly not in the form of decreasing expense ratios – that they benefit investors, as they’re supposed to.

© Oaktree Capital Management, L.P. All Rights Reserved Because of his conviction that markets are efficient, Charley recommended passive investing as the best way to end up the winner – let others try the tough shots and fail. Oaktree’s view is a little different. Although we believe in the existence of inefficient markets as well as efficient ones, we still view the avoidance of losers as a wonderful foundation for investment success. Thus we diversify our portfolios, limit the fundamental risk we’ll take, try to buy things that provide downside protection, and emphasize senior securities. We, too, try to win by not losing. U Which Team Do You Want Out There? I recently came up with a new sports metaphor that handily illustrates a crucial choice each investor has to make. It goes like this: Think about a football game. The offense has the ball. They have four tries to make ten yards. If they don’t, the referee blows the whistle. Off the field goes the offense and on comes the defense, whose job it is to stop the other team from advancing the ball. Is football a good metaphor for your view of investing? Well I’ll tell you, it isn’t for mine. In investing there’s no one there to blow the whistle; you rarely know when to switch from offense to defense; and there aren’t any time-outs during which to do it. No, I think investing is more like the “football” that’s played outside the U.S. – soccer. In soccer, the same eleven players are on the field for essentially the whole game.

For example, there may be incentives to steer capital to a brokerage house's in-house-managed funds as opposed to selling competing funds – because a dollar invested in an in-house fund brings the firm more profit. Once I described a fund to a marketer in terms of its current yield, yield to maturity and yield to call. He said, "Forget about that; let's talk about the thing that matters most: YTB" . . . meaning "yield to broker." There was no doubt where his motivation came from. UIssues Regarding Expenses Most mutual funds operate in "efficient markets," where it's hard for one portfolio manager to get an edge versus the others. It's rare in the long run for any fund to beat its market benchmark or the other funds of similar riskiness in its niche. In efficient markets, expense minimization is the surest route to better net results, and it's for this reason that Jack Bogle pioneered the creation of index mutual funds. The performance of an index fund is certain to mirror that of the market, and expenses truly are minimized. But almost all mutual funds are actively managed, and their expenses are anything but minimized.  The average mutual fund carries investment management fees far above those paid by institutional investors, even those investing far smaller amounts of money.

© Oaktree Capital Management, L.P. All Rights Reserved  The administrative expenses borne by the funds are high and, most significantly, have not demonstrated a tendency to decline in percentage terms as the size of funds has increased. That is, they haven't reflected any economies of scale.  Many fund shareholders pay continuing marketing charges. Why should the costs of selling funds be borne by the shareholders? The usual response is that a bigger fund benefits its shareholders. But then, shouldn't increasing size result in a declining expense ratio?  Even as the total assets of the top 25 equity funds were increasing 845 times over the last 51 years, the average expense ratio rose from .64% of assets to 1.50%, an increase of 134%. (Source: "The Mutual Fund Industry in 2003: Back to the Future," by John C. Bogle) As the total assets of the top 25 equity funds grew from $2.2 billion in 1951 to $1.9 UtrillionU in 2002, the charges for managing and administering a dollar of assets more than doubled. One wonders how many of the "diligent, independent" directors resisted those increases. * * * Are mutual funds good for America? In delivering market participation to retail investors and capital to America's companies, they're invaluable. In hyping hot investments and charging high fees for modest performance, they provide no great service. Are mutual funds safe vehicles for investing? They're no safer than the markets in which they invest, or passive funds.

However, the index fund industry has grown up in the last thirty years and made it clear that average performance can be accessed much more cheaply and dependably through passive management than through active management. Thus the raison d'etre of the active managers became beating the market.

© Oaktree Capital Management, L.P. All Rights Reserved In this simple equation, α is the symbol for alpha, β represents beta, and x is the return of the market. Alpha is best thought of as a portfolio manager's differential skill or value added. It is the ability to generate performance unrelated to movement of the market. Index funds don't aspire to alpha. They're managed by people who know they don't have alpha (actually, most believe no one has any), and they simply strive to reflect the market's movements – no better and no worse. Active managers manage actively because they think they have alpha. They charge for it, and they should be able to demonstrate it. However, many without it seem to have gotten away with charging for it over the years. Beta is the extent to which a portfolio reflects the return of the market. A portfolio with a beta of 1 and no alpha will move up and down exactly as does the market. A beta of 2 means it will move twice as fast in both directions. A beta of .5 means it'll move half as fast. A beta of zero means a total lack of correlation – the much sought-after "market neutral" fund, where all of the return comes from investor skill. A negative beta means an inverse correlation (a short position on an index fund is the best example). I believe the alpha/beta model is an excellent way to assess portfolios, portfolio managers, investment strategies and asset allocation schemes.

Most active managers go through times when their biases or their guesses lead them to do things that beat their assigned benchmark, which they attribute to their skill, and times which are the opposite, which they attribute to being blindsided by the unforeseeable (or to some defect in the benchmark). But these are two sides of the same coin, and in the long run the average manager adds little. Usually, active management will not allow you to beat the stock market, or to enjoy the fruits of the market without fully bearing its risk. UIndexed equitiesU – Thirty years or so ago, investors began to concede that while it was desirable to participate in the stock market, it wasn't worth trying to beat it. Under prodding from academics at the University of Chicago and practitioners such as John Bogle of Vanguard, there began a trend toward index funds, with their low costs and assured inability to underperform. The essence of index investing was a "passive portfolio" that represented a relatively unbiased sample of the universe of stocks. The Standard and Poors' 500 was the immediate choice and quickly became synonymous with "stocks" and "the market." With every period in which active managers underperformed, the trend toward indexing got another boost. The percentage of equities held via index funds rose. In the mid-to- late 1990s, when large-cap growth stocks hogged the spotlight, passive investing outperformed. (That's an oxymoron, isn't it?)

It can best be described as "degree of responsiveness" to the market, or "relative volatility." An S&P index fund will have a beta of 1.0 relative to the S&P 500 (that is, it will go up and down at the same rate as the S&P). An S&P index fund leveraged two to one would have a beta of 2.0 (i.e., it will have twice the response). A portfolio consisting of half S&P index fund and half cash will have a beta of .5. A defensive equity portfolio might be expected to have a beta of .7. Turning up your beta, whether through the use of leverage or by emphasizing more volatile holdings, is certainly one way to try to add to your return. Under investment theory it's the only way, since "beta x the market's return" is the only non-zero term in the above equation (more on this later). The trouble with relying on a high beta to enhance your return is that it's entirely symmetrical. It cuts both ways, subtracting as much when it's wrong as it adds when it's right, which means that it does nothing to increase your expected return unless the underlying decisions are right.Vegas

But if you think about it, the two principal sources of tracking error are (a) over- and under-weightings of the securities in the index and (b) inclusion of off-index securities. So it's obviously possible for tracking error to be too low; an index fund would have zero tracking error, but that's not what clients hire active managers to create. Thus we have a client who monitors our tracking error and complains when it's too low, because they want to see active bets being made.

© Oaktree Capital Management, L.P. All Rights Reserved * * * This last point illustrates what I think should be the role of theory in our industry. In short, I think, theory should UinformU our decisions but not dominate them. If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it's possible to know more than everyone else and regularly beat heavily populated markets. We can buy securities for their returns but ignore their risk. We can buy fifty correlated securities and mistakenly think we've diversified. When I think of the impact of being blind to theory, I flash back to 1970 and the frighteningly simplistic rationale behind my colleagues' expectation of 12% a year from stocks: if they could emulate the historic 10% return with ease through indexing, it should be a snap to add a couple of percent with just a little effort. But swallowing theory whole can make us turn the process over to a computer and miss out on the contribution skillful individuals can make. The image here is of the efficient-market-believing finance professor who takes a walk with a student. "Isn't that a $10 bill lying on the ground?" asks the student. "No, it can't be a $10 bill," answers the professor. "If it were, someone would have picked it up by now." The professor walks away, and the student picks it up and has a beer. So how do we balance the two? By applying informed common sense. At Chicago, I spent a wonderful semester with Professor James Lorie.