Howard Marks on Volatility vs Risk

” • The flaws, potential pitfalls, and unfulfillable promises that investors readily overlook when things are going well invariably lead to disillusionment and loss when the optimism surrounding the new thing turns out to have been excessive or the prices paid simply turn out to have been too high. When Mark Twain purportedly said, “History does not repeat itself, but it does rhyme,” this must be the kind of recurring pattern he had in mind. I consider it one of the eternal truths in investing. Does That Apply to Direct Lending? I think it’s fair to say aspects of this progression occurred over the last 15 years in direct lending, a part of the private credit universe: • A new form of financing was developed. • With banks less willing to lend, the demand for financing from private equity exceeded the supply. That allowed the early direct lenders to demand high interest rates and strong protections through robust loan documents. • The low interest rates of the 2010s made the higher prospective returns on direct lending appear very attractive, especially given that returns could be levered through low-cost borrowing. • Institutional investors noted the attractiveness of the early loans and joined the party. • No doubt that attractiveness was enhanced by the fact that private loans don’t exhibit much price volatility, since there’s no market for them to mark to. That might have let their advocates say, “They’ll deliver high risk-adjusted returns,” but it wasn’t right.

They could reasonably have been expected to deliver high volatility-adjusted returns (that’s what Sharpe ratios are), but I insist strenuously that risk and volatility aren’t the same thing. Direct loans embody no less credit risk than liquid credit instruments such as high yield bonds and broadly syndicated loans. It just isn’t reflected as readily in prices. • Hundreds of investment firms offered their services in direct lending, the vast majority of which entered the private credit market after the end of the Global Financial Crisis, meaning they’d never been tested in rough times. Regardless, they were given plenty of money to manage. • The arrival of many new managers and a great deal of incremental capital caused lenders to compete to make direct loans by accepting lower yields, narrower yield spreads, and reduced safety. Some managers were doubtless motivated to lower their standards in order to put a lot of capital to work.underwriting

As a result of all the above, a significant portion of direct loans were made to software companies, which were often acquired at high EBITDA multiples of ~20x and with high leverage ratios. Now, suddenly, software company debt is in the news. Over the last year or two, artificial intelligence has significantly reduced the need for humans to write code (that is, program computers or write software), largely relegating coders to instructing AI models what to do. The market for software company stocks and debt didn’t react much in 2024-25. Then, in November 2025, Anthropic released a powerful new model for coding, followed in late January by the release of 11 “plug-ins” to automate tasks in a number of fields. It seems a cognitive tipping point was reached in the first days of February. Investors finally took notice of the negatives that had accumulated, and the private credit market has faced scrutiny and volatility ever since: • Worry about software debt made investors in semi-liquid public vehicles put in for redemptions. • Limits on redemptions caused investors to question the safety of their investments. • The process through which some investors got out at the stated net asset value might have caused those remaining to question whether the NAVs people exited at were overstated and if so what the impact might be on them. • When funds limited redemptions, investors might reasonably have concluded that they should put more shares in for withdrawal next time.

The chapter I didn’t plan to write – and the one that became the most important chapter in the book and one of the longest – was the one titled “The Cycle in Attitudes Toward Risk.” Security prices fluctuate much more than do the intrinsic value and prospects of the underlying companies, and the main reason for this is the extreme volatility in the way people feel about risk. When the economy is humming, companies are reporting growing earnings, security prices are rising, and profits are piling up, people say things like: “Risk is my friend. The more risk I take, the more money I make. And anyway, I don’t see anything to worry about.are

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Finally, I think it’s important to note that if, on the other hand, the plan does end up with enough money to pay benefits, that doesn’t necessarily mean its board and staff did a good job. Before coming to that conclusion, one would need to gauge how the portfolio would have done if a different environment had unfolded – that is, to consider “alternative histories” in the way proposed by Nassim Nicholas Taleb in Fooled by Randomness. If the portfolio wouldn’t have done well under other scenarios, the plan’s ability to pay benefits might be attributed solely to the fact that the one that unfolded did so. In that case, the plan’s success might be more a matter of luck than skill. But this isn’t an easy analysis to perform. On the Subject of Volatility I was very glad to hear that the board members ranked the Sharpe ratio last among six possible performance metrics and on average considered avoiding volatility in the sponsor’s contributions less of a priority than the ability to pay benefits or attain fully funded status. Most of the members thought it was important to balance stable contributions and the pursuit of high returns, although some did rank contribution stability higher than the level of return. Obviously, this is a challenging question for a board concerned with both the need to pay benefits and the desire to limit the cost to the sponsor.

In future memos, I’m likely to harp on my view that investors pay too much attention to volatility. It’s absolutely essential for investors to think about limiting their risk, but I don’t think volatility is the risk they should be most concerned with. Regardless, much of the investing community has accepted volatility as the best indicator of risk – primarily, I think, because it’s the only way to come up with a number for risk – and that has led to excessive attention being paid to it. I’ll make a controversial statement here: in pure investment terms, there’s no intrinsic reason for long-term investors to be concerned with volatility (as distinguished from the risk of permanent loss). Warren Buffett famously says he’d “rather earn a lumpy 15% return than a smooth 12%.” Why wouldn’t everyone? In my opinion, the main reasons for concern over fluctuating market prices are situational, institutional, political, career-related, psychological, and emotional. I call these things “externalities,” and because they’re external to the investment process, a potentially volatile investment can be risky for some investors and not for others.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Research from Barclays indicates that since the average high yield bond is now higher in creditworthiness, today’s average yield spread provides a good bit more compensation per unit of credit risk today than it did at the “all-time tight” of 2007. • Active credit managers strive to reduce (a) the incidence of default in their portfolios and (b) the percentage of capital lost when defaults occur. Since the historical spreads have been adequate to protect against average credit losses in the past, that means they’ve proved more than adequate for investors with superior credit discernment. For high yield bond managers with the ability to reduce credit losses through active management, there’s a greater likelihood that spreads will prove sufficient to offset future credit losses. For all these reasons plus one more, I believe the concern about historically narrow spreads is very much overblown. My additional point is that spread widening is a short-term phenomenon, analogous to volatility in stocks. If the yield spread widens, increasing the demanded yield, that results in a price decline for bondholders. But the price decline is temporary, whereas the higher interest payments are received every year . . . and then the bond eventually returns to par at maturity (assuming it performs). I did some research with Oaktree’s Nicole Adrien to test this thesis.

For example: • An AI stock can be a risky holding for the manager of a mutual fund that’s priced daily and subject to daily withdrawals – or for an investor who’s likely to panic during a market crash and sell at the bottom – but much less so for a sovereign wealth fund where the money is unlikely to be withdrawn and there’s no requirement to publish financials and satisfy public opinion. • An investor whose compensation is based on metrics that penalize volatility may consider a publicly traded bond riskier than a private loan from the same issuer that doesn’t mark to market, even though the risk of default is the same for both. If it’s true that an asset’s volatility can bring risk for some investors but not others, then clearly the risk doesn’t lie in the investment, but in something in the investor’s environment. While I think the risk of permanent loss is the most important investment risk, I recognize that volatility can be a material real-world risk for some investors. My experience with the pension fund session reminded me that rapidly fluctuating portfolio values can require fluctuating contributions from pension plan sponsors.legitimate

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: consideration for people with responsibility for pension plans. It’s absolutely internal to them and their process. And, of course, pension funds are but one example of the type of investor who may consider volatility a risk. University endowments are another example. Typically, universities rely upon an annual “draw” from the endowment to fund a material portion of their operating expenses. Volatility in the value of the endowment can affect the amount of that draw and require unplanned changes to a university’s operations. We saw this very clearly when the Global Financial Crisis hit in 2008. Choice of Investment Approach The consultant did a good job of covering questions regarding strategies and tactics, and the board gave good answers. Here are a few of the areas they touched on: • All board members agreed that it’s impossible to foresee the future, and thus that the portfolio should be built to prepare for “all environments” rather than base performance expectations on the ability to time markets. Of course this is the right attitude, even though it’s impossible to (a) specify “all environments” or (b) build a portfolio that entails the risk inherent in investing but is capable of performing well in all environments. • A substantial majority of the members said they’re comfortable with using leverage at 15-20% of the plan’s assets. I think this is reasonable.

My responses generally go like this: • Like anything else, there are pros and cons. The most obvious pro is that, to compensate for the lack of liquidity, private credit offers higher yields than public credit. The second is that private credit managers are able to offer funds (and thus returns) that are levered, which isn’t true of most public credit funds. The main negative stems from the absence of a market for the loans, and thus their illiquidity and the difficulty of actively managing holdings. Further, because there’s no market, private credit can’t actually mark to market. A final negative is that the fees are higher on private credit investing than on public credit, often including an incentive fee. • What about the lack of marking to market, and the resulting low level of volatility? It’s obviously unrealistic to think the value of private loans doesn’t fluctuate.hand,

But above average personnel turnover may be indicative of a poor hiring process, an unreasonable performance assessment process, or poor management practices. At minimum, these possibilities must be considered. The Bottom Line In general, I very much liked what I heard in the session, and I think these are the most important observations: • The board members are happy to take less than 100% of the risk the plan’s finances might permit. • They prefer to forego some return potential in order to avoid the full force of market declines. • They have little concern for their ranking within their peer group. • They have relatively little interest in volatility-adjusted performance metrics. • They’re rightly concerned about how to assess the performance of the investment team and the portfolio they produce.

fiscal deficits and national debt show no sign of improvement, and worldwide concern over them seems to be increasing. • Nevertheless, with the outlook possibly diminished on balance, U.S. stock prices are up. While earnings are expected to rise, stock prices are up more. Thus, regardless of where it stood as this year began, the value proposition in U.S. stocks seems to be less appealing today than it was at year-end – and even then, it wasn’t great. What are the indicators of investor behavior and the resulting price/value relationship? • The elevated p/e ratio on the S&P 500 is the tentpole of the argument that valuations are optimistic. • According to the Financial Times (July 25), “Stocks in the S&P 500 are now valued at more than 3.3 times their [companies’] sales, according to Bloomberg, an all-time high.” • From the same FT article, “A Barclays ‘equity-euphoria indicator,’ a composite of derivative flows, volatility and sentiment, has surged to twice its normal level, into territory associated with asset bubbles.” • Warren Buffett’s favorite indicator – the ratio of the aggregate market capitalization of U.S. stocks to U.S. GDP – is also at an all-time high. It’s especially worth noting that the U.S. market cap has been restrained by companies’ tendency to wait longer these days before going public and by the fact that many companies have been taken private in buyouts. Thus, this elevated indicator could be even more troubling than it appears.

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.

It’s astounding to think what these businesses have endured – dozens of wars, emperors, catastrophic earthquakes, tsunamis, depressions, on and on, endlessly. And yet they keep selling, generation after generation. These ultra-durable businesses are called “shinise,” and studies of them show they tend to share a common characteristic: they hold tons of cash, and no debt. That’s part of how they endure centuries of constant calamities. Clearly, all else being equal, people and companies that are indebted are more likely to run into trouble than those that aren’t. And it goes without saying that a home or car that hasn’t been used as collateral for a loan can’t be foreclosed on or repossessed. It’s the presence of debt that creates the possibility of default, foreclosure, and bankruptcy. Does that mean debt is a bad thing and should be avoided? Absolutely not. Rather, it’s a matter of whether the amount of debt is appropriate relative to (a) the size of the overall enterprise and (b) the potential for fluctuations in the enterprise’s profitability and asset value. Housel frames the issue by introducing the idea of potential volatility over one’s lifetime: “Not just market volatility, but . . . world and life volatility: recessions, wars, divorces, illness, moves, floods, changes of heart, etc.” With no debt, he postulates, we’re likely to survive all but the most infrequent, most volatile events.

But in a succession of illustrations, Housel shows that as the level of one’s indebtedness increases, the range of volatility one can withstand narrows, until at a very high level of debt, only the tamest of environments are survivable. As Housel puts it, “as debt increases, you narrow the range of outcomes you can endure in life.” © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Housel’s approach to thinking about debt – and especially his illustrations – reminded me of my December 2008 memo, Volatility + Leverage = Dynamite. (Unless otherwise indicated, this memo is the source of the quotations that follow; in all cases, emphasis is in the original.) In that memo, I used a series of simple graphics to show that the lower a company’s debt load is, the greater the decline in fortune it could survive. And I made the following observation about the root cause of the Global Financial Crisis, which was in full force at the time of the memo: . . . the amount of borrowed money – leverage – that it’s prudent to use is purely a function of the riskiness and volatility of the assets it’s used to purchase. The more stable the assets, the more leverage it’s safe to use. Riskier assets, less leverage. It’s that simple. One of the main reasons for the problem today at financial institutions is that they underestimated the risk inherent in assets such as home mortgages and, as a result, bought too much mortgage-backed paper with too much borrowed money. Portfolios, Leverage, and Volatility The reason for taking on debt – i.e., using what investors call “leverage” – is simple: to increase so-called capital efficiency. Debt capital is usually cheap relative to the expected returns that motivate equity investments and thus relative to the imputed cost of equity capital.

This was still very low by historical standards, but, according to the suddenly popular “Sahm Rule” (don’t complain to me; I’d never heard of it either), since 1970, an increase in the three-month average unemployment rate of 0.5 percentage points or more from the low of the prior 12 months has never occurred without the economy already being in recession. Around the same time, Warren Buffett’s Berkshire Hathaway announced that it had sold off a good part of its massive holding of Apple shares. In all, this news constituted a triple whammy. The resulting flip-flop from optimism to pessimism set off a significant stock market rout. The S&P 500 fell on three consecutive trading days – August 1, 2, and 5 – by a total of 6.1%. The replay of the mistakes I’ve witnessed for decades was so obvious that I can’t resist cataloging them below. What’s Behind the Market’s Volatility? On the first two days of August, I was in Brazil, where people often asked me to explain the sudden collapse. I referred them to my 2016 memo On the Couch. Its key observation was that in the real world, things fluctuate between ‘pretty good’ and ‘not so hot,’ but in investing, perception often swings from ‘flawless’ to ‘hopeless.’ That says about 80% of what you need to know on the subject. If reality changes so little, why do estimates of value (that’s what security prices are supposed to be) change so much? The answer has a lot to do with changes in mood.

Thus, it’s efficient to use it in lieu of equity. In casinos, I’ve heard the pit boss say, “The more you bet, the more you win when you win.” Likewise, for a given amount of equity capital, (a) the more debt capital you use, the more assets you can own and (b) the more assets you own, the greater your profits will be . . . when things go well. But few people talk about the downside. The pit boss never says, “. . . and the more you lose when you lose.” Likewise, when your assets decline in value, the more leverage you’ve employed, the more equity loss you’ll suffer. The magnification of gains and losses stemming from leverage is typically symmetrical: a given amount of leverage amplifies gains and losses similarly. But levered portfolios face a downside risk to which there isn’t a corresponding upside: the risk of ruin. The most important adage regarding leverage reminds us to “never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average.” To survive, you have to get through the low points, and the more leverage you carry (everything else being equal), the less likely you are to do so. . . . it’s important to recognize the role of volatility.

Even if losses aren’t permanent, a downward fluctuation can bring risk of ruin if a portfolio is highly leveraged and (a) the lenders can cut off credit, (b) investors can be frightened into withdrawing their equity, or (c) the violation of regulatory or contractual standards can trigger forced selling. Obviously, the greatest leverage-related losses occur when the potential for downward fluctuations has been underestimated for a meaningful period of time and thus the use of leverage has become excessive. Generally speaking, “normal levels of volatility” – those seen on a regular basis and documented through historical statistics – are used in investors’ calculations and reflected in the amounts of leverage they employ. It’s the isolated “tail events” that saddle levered investors with the greatest losses: © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Insistence on preserving capital – or, secondarily, on limiting the portfolio’s volatility – calls for an emphasis on defense, which precludes pursuing maximum growth. • Correspondingly, a decision to strive to maximize growth requires an emphasis on offense, meaning preservation of capital and steadiness must be sacrificed to some degree. It’s one or the other. You can’t simultaneously emphasize both preservation of capital and maximization of growth, or defense and offense. This is the fundamental, inescapable truth in investing. The questions listed on page one are just details, the options available for reaching your targeted risk posture. If you think about portfolio construction in this sense – looking for the right balance between offense and defense – it becomes clear that the goal should be optimization, not maximization. To my mind, it shouldn’t be “wealth,” but “wealth pursued in an appropriate way, taking into account the investor’s wants and needs.” Many people think the proper goal in investing is achieving the highest return. More sophisticated thinkers understand – either intellectually or intuitively – that the goal should be to achieve the best relationship between return and risk.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The problem is that extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen – that assumptions regarding risk were too conservative. Thus, it becomes tempting to relax rules and increase leverage. And often this is done just before the risk finally rears its head. As Nassim Nicholas Taleb wrote in Fooled by Randomness: Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security . . . Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. . . . One is thus capable of unwittingly playing Russian roulette – and calling it by some alternative “low risk” name. . . . In all aspects of our lives, we base our decisions on what we think probably will happen. And, in turn, we base that to a great extent on what usually happened in the past. We expect results to be close to the norm most of the time, but we know it’s not unusual to see outcomes that are better or worse.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Which of the two is “better,” ownership or debt? We can’t say. In a market with any degree of efficiency – that is, rationality – it’s just a tradeoff. A higher expected return with further upside potential, at the cost of greater uncertainty, volatility, and downside risk? Or a more dependable but lower expected return, entailing less upside and less downside? The choice between the two is subjective, largely a function of the investor’s circumstances and attitude toward bearing risk. That means the answer will be different for different investors. Choosing the Offense/Defense Balance I’ve previously expressed my view that, as a starting point, every investor or their investment manager should identify their appropriate normal risk posture or offense/defense balance. For each individual or institution, this decision should be informed by the investor’s investment horizon, financial condition, income, needs, aspirations, responsibilities, and, crucially, intestinal fortitude, or their ability to stomach ups and downs.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: January’s memo Easy Money: The Manchester Banker John Mills commented perceptively [in 1865] that “as a rule, panics do not destroy capital; they merely reveal the extent to which it has previously been destroyed by [the taking on of excessive leverage in good times].” Using Debt Prudently As with so many aspects of investing, determining the proper amount of leverage has to be a function of optimizing, not maximizing. Given that leverage magnifies gains when there are gains and that investors only invest when they expect there to be gains, it can be tempting to think the right amount of leverage is “all you can get.” But if you bear in mind (a) leverage’s potential to magnify losses when there are losses and (b) the risk of ruin under extreme negative circumstances, investors should usually use less than the maximum available. Successful investments, perhaps enhanced by the moderate use of leverage, should usually provide a good-enough return – something few people think about in good times. Here’s how I summed it up in Volatility + Leverage = Dynamite: Clearly, it’s difficult to always use the right amount of leverage, because it’s difficult to be sure you’re allowing sufficiently for risk. Leverage should only be used on the basis of demonstrably cautious assumptions.

But if they understand the real implications of increased risk, as suggested by Figures 6 and 7, then they might opt for something more moderate. The Role of Alpha and Beta All the foregoing assumes markets are efficient: • As risk increases in an efficient market, expected return increases proportionally. Or maybe that’s better stated the other way around: as expected return increases, so does the accompanying risk (the uncertainty surrounding the outcome and the likelihood of a bad one). Thus, no position on the risk continuum (for example, in Figure 6) is “better” than any other. It’s all just a matter of where you want to come out in terms of absolute riskiness, or what absolute level of return you © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

The reason for this is the academic view that, in an efficient market, (a) all assets are priced fairly relative to each other, such that there are no bargains or over-pricings to take advantage of and (b) there’s no such thing as alpha, which I define as “gains resulting from superior individual skill.” As a result, there’s nothing to be gained from active decision making: no asset class, strategy, security or manager is “better” than any other. They merely vary in terms of risk and resulting return. Also in the academic view, since there’s no such thing as alpha, the only thing that differentiates assets is their beta, or their relative volatility, the extent to which they reflect market movements. In the theory, it’s beta that expected returns are proportional to. Now it’s time for me to assert strenuously that, in reality, markets are not efficient in the academic sense of always being “right.” Markets may do an efficient job of (a) rapidly incorporating new information and (b) accurately reflecting the resulting consensus opinion concerning the right price for each asset given the totality of information, but that opinion can be far from correct. For that reason, gains can be achieved by choosing skillfully among the options: • some assets, markets or strategies can offer a better risk/return bargain than others, and • some managers can operate within a market or strategy to produce superior risk-adjusted returns.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Of course, your asset allocation process will be informed by how you rate your ability to identify and access superior strategies and superior managers, recognizing that doing so isn’t easy. * * * Moving on to the real world, I want to make some important observations regarding one of Oaktree’s key sectors, non-investment grade credit (defined as performing non-government debt): • The prospective returns in this area today are much higher than they were in the 2009-21 period. • These returns, starting at roughly 7% on public credit and 10% on private credit, are competitive with the historical returns on equities and capable of helping many investors toward their overall return targets. • Because of their contractual nature, the returns from credit are likely to prove much more dependable than ownership returns. In my view, the thought process set forth in this memo leads to the conclusion that investors should increase their allocations in this area if they are (a) attracted by returns of 7-10% or so, (b) desirous of limiting uncertainty and volatility, and (c) willing to forgo upside potential beyond today’s yields to do so. For me, that should include a lot of investors, even if not everyone. My recommendation at this time is that investors do the research required to increase their allocation to credit, establish a “program” for doing so, and take a partial step to implement it.

Here’s how I put it 33 years ago in that first memo, titled The Route to Performance: I feel strongly that attempting to achieve a superior long-term record by stringing together a run of top-decile years is unlikely to succeed. Rather, striving to do a little better than average every year – and through discipline to have highly superior relative results in bad times – is: • less likely to produce extreme volatility, • less likely to produce huge losses which can’t be recouped and, most importantly, • more likely to work (given the fact that all of us are only human). Simply put, what [General Mills’s] record tells me is that, in equities, if you can avoid losers (and losing years), the winners will take care of themselves. I believe most strongly that this holds true in my group’s opportunistic niches as well – that the best foundation for above-average long-term performance is an absence of disasters. As you can see, my dinner with Dave was a seminal event; his approach was clearly the one for me. (Incidentally, I want to share that after decades of not having been in touch, Dave was among the many kind people who wrote in recent months to encourage me vis-à-vis my health issue. This is a great example of the many personal dividends my career has paid.) Putting It in Brief That first memo, and the bit cited above, include a phrase you’ve likely heard from Oaktree: If we avoid the losers, the winners will take care of themselves.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: The Pendulum in International Affairs As regular readers of my memos and books know, I’m strongly interested in – you might say obsessed with – the concept of the pendulum. The following is only a partial list of my writings on the subject: • My second memo, written in April 1991, was creatively titled First Quarter Performance. It talked about the oscillation in securities markets between euphoria and depression; between celebrating positive developments and obsessing over negatives; and thus between overpriced and underpriced assets. • On Regulation, written in March 2011, discussed the outlook for rulemaking stemming from the Global Financial Crisis. I said future developments were likely to be driven by the long-term pendulum-like swing in attitudes on that subject. Over time, those attitudes tend to fluctuate between “the markets best serve the country when they’re unfettered by rules” to “we need the government to protect us from participants’ misbehavior.” • In The Role of Confidence, from August 2013, I discussed the way shifts in fundamentals are translated into market volatility by often-excessive swings in investor confidence. • And in my 2018 book, Mastering the Market Cycle, I interrupted my discussion of the various cycles – in the economy, corporate profits, credit availability, etc.

What Doesn’t Matter: Short-Term Performance Given the possible contributors to short-term investment performance, reported results can present a highly misleading picture, and here I’m talking mostly about superior gains in good times. I feel there are three ingredients for success during good times – aggressiveness, timing, and skill – and if you have enough aggressiveness at the right time, you don’t need that much skill. We all know that in good times, the highest returns often go to the person whose portfolio incorporates the most risk, beta, and correlation. Having such a portfolio isn’t a mark of distinction or insight if the investor is a perma-bull who’s always positioned aggressively. Finally, random events can have an overwhelming impact on returns – in either direction – in a given quarter or year. One of the recurring themes in my memos is the idea that the quality of a decision cannot be determined from the outcome alone. Decisions often lead to negative outcomes even when they’re well-reasoned and based on all the available information. On the other hand, we all know people – even occasionally ourselves – who’ve been right for the wrong reason. Hidden information and random developments can © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

” What Doesn’t Matter: Volatility I haven’t written much about volatility, other than to say I strongly disagree with people who consider it the definition or essence of risk. I’ve described my belief that the academics who developed the Chicago School theory of investment in the early 1960s (a) wanted to examine the relationship between investment returns and risk, (b) needed a number quantifying risk that they could put into their calculations, and (c) undoubtedly chose volatility as a proxy for risk for the simple reason that it was the only quantifiable metric available. I define risk as the probability of a bad outcome, and volatility is, at best, an indicator of the presence of risk. But volatility is not risk. That’s all I’m going to say on that subject. What I want to talk about here is the extent to which thinking and caring about volatility has warped the investing world over the 50-plus years that I’ve been in it. It was a great advantage for me to have attended the Graduate School of Business at the University of Chicago in the late ’60s and to have been part of one of the very first classes that was taught the new theories. I learned about the efficient market hypothesis, the capital asset pricing model, the random walk, the importance of risk aversion, and the role of volatility as risk. While volatility wasn’t a topic of conversation when I got into the real world of investing in 1969, practice soon caught up with theory.

In particular, the Sharpe ratio was adopted as the measure of risk-adjusted return. It’s the ratio of a portfolio’s excess return (the part of its return that exceeds the yield on T-bills) to its volatility. The more return per unit of volatility, the higher the risk-adjusted return. Risk adjustment is an essential concept, and returns should absolutely be evaluated relative to the risk that was taken to achieve them. Everyone cites Sharpe ratios, including Oaktree, because it’s the only quantitative tool available for the job. (If investors, consultants, and clients didn’t use the Sharpe ratio, they’d have no metric at all, and if they tried to substitute fundamental riskiness for volatility in their assessments, they’d find that there’s no way to quantify it.) The Sharpe ratio may hint at risk-adjusted performance in the same way that volatility hints at risk, but since volatility isn’t risk, the Sharpe ratio is a very imperfect measure. Take, for example, one of the asset classes I started working with in 1978: high yield bonds. At Oaktree, we think moderately-above-benchmark returns can be produced with substantially less risk than the © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: benchmark, and this shows up in superior Sharpe ratios. But the real risk in high yield bonds – the one we care about and have a history of reducing – is the risk of default. We don’t much care about reducing volatility, and we don’t take conscious steps to do so. We believe high Sharpe ratios can result from – and perhaps are correlated with – the actions we take to reduce defaults. Volatility is particularly irrelevant in our field of fixed income or “credit.” Bonds, notes, and loans represent contractual promises of periodic interest and repayment at maturity. Most of the time when you buy a bond with an 8% yield, you’ll basically get the 8% yield over its life, regardless of whether the bond price goes up or down in the interim. I say “basically” because, if the price falls, you’ll have the opportunity to reinvest the interest payments at yields above 8%, so your holding-period return will creep up. Thus, the downward price volatility that so many revile is actually a good thing – as long as it doesn’t presage defaults. (Note that, as indicated in this paragraph, “volatility” is often a misnomer. Strategists and the media often warn that “there may be volatility ahead.” What they really mean is “there may be price declines ahead.” No one worries about, or minds experiencing, volatility to the upside.) It’s essential to recognize that protection from volatility generally isn’t a free good.

Reducing volatility for its own sake is a suboptimizing strategy: It should be presumed that favoring lower- volatility assets and approaches will – all things being equal – lead to lower returns. Only managers with superior skill, or alpha (see page 11), will be able to overcome this negative presumption and reduce return less than they reduce volatility. Nevertheless, since many clients, bosses, and other constituents are uncomfortable with radical ups and downs (well, mostly with downs), asset managers often take steps to reduce volatility. Consider what happened after institutional investors began to pile into hedge funds following the three-year decline of stocks brought on by the bursting of the tech bubble in 2000. (This was the first three-year decline since 1939-41.) Hedge funds – previously members of a cottage industry where most funds had a few hundred million dollars of capital from wealthy individuals – did much better than stocks in the downdraft. Institutions were attracted to these funds’ low volatility, and thus invested billions in them. The average hedge fund delivered the stability the institutions wanted. But somewhere in the shuffle, the idea of earning high returns with low volatility got lost. Instead, hedge fund managers pursued low volatility as a goal in itself, since they knew it was what the institutions were after.

As a result, over roughly the last 18 years, the average hedge fund delivered the low volatility that was desired, but it was accompanied by modest single-digit returns. No miracle there. Why do I recite all this? Because volatility is just a temporary phenomenon (assuming you survive it financially), and most investors shouldn’t attach as much importance to it as they seem to. As I wrote in I Beg to Differ, many investors have the luxury of being able to focus exclusively on the long term . . . if they will take advantage of it. Volatility should be less of a concern for investors: • whose entities are long-lived, like life insurance companies, endowments, and pension funds; • whose capital isn’t subject to lump-sum withdrawal; • whose essential activities won’t be jeopardized by downward fluctuations; • who don’t have to worry about being forced into mistakes by their constituents; and • who haven’t levered up with debt that might have to be repaid in the short run. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Most investors lack some of these things, and few have them all. But to the extent these characteristics are present, investors should take advantage of their ability to withstand volatility, since many investments with the potential for high returns might be susceptible to substantial fluctuations. Warren Buffett always puts it best, and on this topic he usefully said, “We prefer a lumpy 15% return to a smooth 12% return.” Investors who’d rather have the reverse – who find a smooth 12% preferable to a lumpy 15% – should ask themselves whether their aversion to volatility is mostly financial or mostly emotional. Of course, the choices made by employees, investment committee members, and hired investment managers may have to reflect real-world considerations. People in charge of institutional portfolios can have valid reasons for avoiding ups and downs that their organizations or clients might be able to stomach in financial terms but would still find unpleasant. All anyone can do is the best they can under their particular circumstances. But my bottom line is this: In many cases, people accord volatility far more importance than they should. An Aside While I’m on the subject of volatility, I want to turn to an area that hasn’t reported much of it of late: private investment funds. The first nine months of 2022 constituted one of the worst periods on record for both stocks and bonds.

Yet many private equity and private debt funds are reporting only small losses for the year to date. I’m often asked what this means, and whether it reflects reality. Maybe the performance of private funds is being reported accurately. (I know we believe ours is.) But I recently came across an interesting Financial Times article provocatively titled, “The volatility laundering, return manipulation and ‘phoney happiness’ of private equity,” by Robin Wigglesworth. Here’s some of its content: The widening performance gap between public and private markets is a huge topic these days. Investors are often seen as the gormless [foolish] dupes falling for the “return manipulation” of cunning private equity tycoons. But what if they are co-conspirators? . . . That’s what a new paper from three academics at the University of Florida argues. Based on nearly two decades worth of private equity real estate funds data, Blake Jackson, David Ling and Andy Naranjo conclude that “private equity fund managers manipulate returns to cater to their investors.” . . . Jackson, Ling and Naranjo’s . . . central conclusion is that “GPs do not appear to manipulate interim returns to fool their LPs, but rather because their LPs want them to do so”.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: line returns, such as IRRs, to their trustees or other overseers. In doing so, these investment managers, whose median tenure of four years often expires years before the ultimate returns of a PE fund are realized, might improve their internal job security or potential labor market outcomes. . . . This probably helps explain why private equity firms on average actually reported gains of 1.6 per cent in the first quarter of 2022 and only some modest mark downwards since then, despite global equities losing 22 per cent of their value this year. (November 2, 2022. Emphasis added) If both GPs and LPs are happy with returns that seem unusually good, might the result be suspect? Is the performance of private assets being stated accurately? Is the low volatility being reported genuine? If the current business climate is challenging, shouldn’t that affect the prices of public and private investments alike? But there’s another series of relevant questions: Mightn’t it be fair for GPs to decline to mark down private investments in companies that have experienced short-term weakness but whose long-term prospects remain bright? And while private investments might not have been marked down enough this year, isn’t it true that the prices of public securities are more volatile than they should be, overstating the changes in long-term value?

Faulty Fed forecasts resulted in faulty forward guidance and increased financial market volatility. (Emphasis added) Lastly on this subject, where are the people who’ve gotten famous (and rich) by profiting from macro views? I certainly don’t know everyone in the investment world, but among the people I do know or am aware of, there are only a few highly successful “macro investors.” When the number of instances of something is tiny, it’s an indication, as my mother used to say, that they’re “the exceptions that prove the rule.” The rule in this case is that macro forecasts rarely lead to exceptional performance. For me, the exceptionalness of the success stories proves the general truth of that assertion. Practitioners’ Need to Predict Forecasts usually tell us more of the forecaster than of the future. – Warren Buffett How many people are capable of making macro forecasts that are valuable most of the time? Not many, I think. And how many investment managers, economists, and forecasters try? Thousands, at a minimum. That raises an interesting question: why? If macro forecasts don’t add to investment success over time, why do so many members of the investment management industry espouse belief in forecasts and pursue them? I think the reasons probably center on these: • It’s part of the job. • Investors have always done it. • Everyone I know does it, especially my competitors. • I’ve always done it – I can’t quit now. • If I don’t do it, I won’t be able to attract clients.

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?

Investors should find a way to keep their hands off their portfolios most of the time. A Special Word in Closing: Asymmetry “Asymmetry” is a concept I’ve been conscious of for decades and consider more important with every passing year. It’s my word for the essence of investment excellence and a standard against which investors should be measured. First, some definitions: • I’m going to talk below about whether an investor has “alpha.” Alpha is technically defined as return in excess of the benchmark return, but I prefer to think of it as superior investing skill. It’s the ability to find and exploit inefficiencies when they’re present. • Inefficiencies – mispricings or mistakes – represent instances when an asset’s price diverges from its fair value. These divergences can show up as bargains or the opposite, over-pricings. • Bargains will dependably perform better than other investments over time after adjustment for their riskiness. Over-pricings will do the opposite. • “Beta” is an investor’s or a portfolio’s relative volatility, also described as relative sensitivity or systematic risk. People who believe in the efficient market hypothesis think of a portfolio’s return as the product of the market’s return multiplied by the portfolio’s beta. This is all it takes to explain results, since there are no mispricings to take advantage of in an efficient market (and so no such thing as alpha).

Thus, alpha is skill that enables an investor to produce performance better than that which is explained purely by market return and beta. Another way to say this is that having alpha allows an investor to enjoy profit potential that is disproportionate to loss potential: asymmetry. In my view, asymmetry is present when an investor can repeatedly do some or all of the following: • make more money in good markets than he gives back in bad markets, • have more winners than losers, • make more money on his winners than he loses on his losers, © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

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

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Given our insistence on risk control, Oaktree’s open-end strategies don’t always keep up with their benchmarks in highly bullish times. The fourth quarter of 2020 presented a potential challenge in that regard, as the market rally (and the low interest rates) encouraged risk-taking and caused the riskiest assets to soar. Thus, we’re happy to report that 10 of the 14 strategies exceeded their benchmarks in the fourth quarter, allowing 9 of them to do so for the full year (all references to returns are before fees). Further, the ups and downs of our quarterly returns suggest we earned our returns with less volatility than the benchmarks. Overall, we’re quite pleased with Oaktree’s investment performance for the year. To reiterate what you already know, none of this was predicated on forecasts. We never tried to predict when the markets would begin to recover from their Covid-19-induced declines. We didn’t know better than anyone else that the new signs of life in the markets in late March were the beginnings of a rally that would take them to all-time highs. We simply favored defensiveness when we considered the markets vulnerable and then turned aggressive when price declines rendered defensiveness no longer appropriate.

economy “is in an environment where we’ve got a lot of volatility, so it’s not at all clear that any of this will pan out the way anybody’s talking about.” (The Wall Street Journal, June 18, emphasis added) © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

For the week, it lost 3.45%. The S&P 500 declined 1.3%, or 55.41 points, to 4166.45 on Friday, losing 1.9% on the week. That broke a three-week streak of gains. The Nasdaq Composite lost 0.9%, or 130.97 points, to 14030.38, as large technology stocks also fell. For the week, it was down 0.3%. Policy makers had signaled Wednesday that they expect to raise interest rates by late 2023, sooner than they had previously anticipated. Sentiment waned again on Friday after Federal Reserve Bank of St. Louis leader James Bullard said on CNBC that he expects the first rate increase even sooner, in late 2022. . . . It isn’t surprising that equities are falling, said ThinkMarkets analyst Fawad Razaqzada. U.S. stocks have hit a series of record highs and have been outpacing the economic recovery since last year. Now traders are repricing that “reflation trade” as they watch the Federal Reserve slowly start to alter its stance on monetary policy. “It was coming,” he said. “This kind of selloff was coming because the market got ahead of itself.” The Cboe Volatility Index, known as Wall Street’s “fear gauge,” climbed to its highest level in weeks. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

This possibility means (a) bonds with maturities much above ten years are obvious candidates for underweighting and (b) inflation beneficiaries should be considered for overweighting, including floating-rate debt, real estate capable of seeing rent increases, and the stocks of companies with the power to pass on price increases and/or the potential for rapid earnings growth. When it comes to finding decent returns in this environment, the options are slim. Investors have plowed capital into the mainstream public “beta” markets. As a result, prospective returns have come down – fully reflecting the reduction in interest rates – and markets have become quite efficient. In most cases, price has converged with – if not run ahead of – intrinsic value. That means it’s harder than ever to outperform, other than by taking on additional risk and being lucky enough to do so in an environment where such action is rewarded. Although no markets are starved for capital these days, there may be alternative “alpha” markets where investment skill can add to returns, hopefully without a commensurate increase in overall risk. Some of this additional return is simply a premium for bearing illiquidity, and the pain suffered by some institutions during the 2008-09 crisis shows how important it is to correctly assess one’s ability to live with illiquidity.

© 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:  As a result, we see a lot of the reaction that greeted my July memo: “the market’s expensive, but I think it has further to go.” How healthy can it be when investors think an asset or market is rich but they’re holding anyway because they think it might go up some more? Fear of missing out (or “FOMO”) is one of the more powerful reasons for investor aggressiveness, and also one of the most dangerous.  Market behavior implies a level of equanimity on investors’ part that could prove unrealistic (and thus subject to reversal). For example, 2017 was the first year in history in which the S&P 500 didn’t decline from high to low by more than 3% at least once. Likewise, in a six-month period late in the year, the VIX (an indicator of the level of volatility implied by investors’ pricing of S&P 500 options) closed below a reading of ten more than 40 days; never before had it done so more than six times in a six-month period (The New York Times, January 14).  It appears many investment decisions are being made today on the basis of relative return, the unacceptability of the returns on cash and Treasurys, the belief that the overpriced market may have further to go, and FOMO. That is, they’re not being based on absolute returns or the fairness of price relative to intrinsic value. Thus, as my colleague Julio Herrera said the other day, “valuation is a lost art; today it’s all about momentum.

”  The potential catalysts for decline that we have to worry about most may be the unknown ones. And although I read recently that bull markets don’t die of old age or collapse of their own weight, I think sometimes they do (a dollar for anyone who can identify the catalyst for the collapse of the bull market and tech bubble in 2000 – it’s not easy). The bottom line of the above is that some people are excited about the fundamentals, and others are wary of asset prices. Both positions have merit, but as is often the case, the hard part is figuring out which one to weight more heavily. As I wrote in September, most people (and certainly the media) want definite answers: in or out? buy or sell? risk-on or risk-off? But it’s rare for answers that simple to be correct. There’s a wide range of possible stances that investors might adopt. At one end of the spectrum there’s maximum aggressiveness (100% invested in high-beta, high-risk assets, or maybe more than 100% through the use of leverage), and at the other there’s maximum defensiveness (100% cash, or perhaps being net short). Most investors are never either of those. And I certainly wouldn’t be either of them today; I’d be someplace in between. That’s easy to say. But where? Closer to the bullish end of the spectrum or the bearish end? Or balancing the two equally? My answer today, as readers know, is that I would favor the defensive or cautious part of the spectrum.

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.

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 ETFs for people who want growth, value, high quality, low volatility and momentum. Going to the extreme, investors can now 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. © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: But what does “passive” mean when a vehicle’s focus is defined so narrowly? Each deviation from the broad indices introduces definitional issues and non-passive, discretionary decisions. Passive funds that emphasize stocks reflecting specific factors are called “smart-beta funds,” but who can say the people setting their selection rules are any smarter than the active managers who are so disrespected these days? Steven Bregman of Horizon Kinetics calls this “semantic investing,” meaning stocks are chosen on the basis of labels, not quantitative analysis. [For example, he points out that because it’s so big and liquid, Exxon Mobil is included in both growth and value ETFs.] There are no absolute standards for which stocks represent many of the characteristics listed above. (“There They Go Again . . . Again” July 2017) According to Wikipedia, “as of January 2014, there were over 1,500 ETFs traded in the U.S. . . .” That compares with 3,599 stocks in the Wilshire 5000 Total Market Index (per Barron’s). To me, the number and variety of ETFs serves as a reminder of the financial industry’s customary eagerness to accommodate people’s desire in good times to “get action” in the markets. And how else should we view the levered ETFs that have been designed to appreciate or depreciate by a multiple of what an index does? That’s the background.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The third level concerns stocks in smart-beta funds. The more a stock is held in non-index passive vehicles receiving inflows (ceteris paribus, or everything else being equal), the more likely it is to appreciate relative to one that’s not. And stocks like Amazon that are held in a large number of smart-beta funds of a variety of types are likely to appreciate relative to stocks that are held in none or just a few. What all the above means is that for a stock to be added to index or smart-beta funds is an artificial form of increased popularity, and it’s relative popularity that determines the relative prices of stocks in the short run. The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced. Like the tech stocks in 2000, this seeming perpetual-motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: (e.g., as they become cheaper or more expensive). The rules have become increasingly complex, and they are able to ‘learn’ (that is, they are ‘conditional’ or ‘contextual’) in that they understand more of the environment.” Constant renewal – not “a formula alone” – seems to be a minimum requirement for any quants’ long-term success. * * * It seems to me that while the members of both fraternities might reject the comparison, quantitative investing has some things in common with smart-beta ETF investing:  Both are rules-based, pursuing the attributes the managers want in their holdings.  In both, once the rules are set, the humans (largely) take their hands off the wheel and leave implementation up to computers. The main differences I see – and they are very substantial – are that:  There’s much more trading in quantitative investing. Since index funds and ETFs are “passive” and thus indifferent to company fundamentals and the attractiveness of security prices, they largely buy and hold. On the other hand, quantitative investors’ computers constantly recheck their portfolios against the algorithms or rules.  The quantitative process is much more . . . quantitative. As Steven Bregman said, smart-beta ETFs buy based on “semantics”: on how securities are labeled (without any quantitative standards for membership in groups).

Quantitative investors, on the other hand, do so based on quantitative assessment of securities’ fundamentals and price. In closing on the subject of quantitative investing, I want to mention a few issues related to timeframe (some of them suggested by my son Andrew).  Most quantitative investing is a matter of taking advantage of standard patterns (the factors that have been correlated with outperformance) and normal relationships (like the usual ratio of one stock’s price to another’s or to the market).  Quants invest on the basis of historic data regarding these things. But what will happen if patterns and relationships are different in the future from those of the past?  Is it important that most quantitative investors have operated only in periods when interest rates were declining, inflation was low and volatility was low, and when the trends in these regards were fairly stable? Will their approaches prove dynamic enough to adjust if rates, inflation and volatility rise or become more variable? And if they do rise or become more variable, what historic data will quants use in their rule-making?  Likewise, is it significant that there’s limited history of investment performance in periods influenced by quants? In other words, will increased quantitative investing influence the effectiveness of quantitative investing, and thus alter the requirements for success? We’ll see, but certainly it can’t be said that most quantitative investors are proven in these regards.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  Finally, it can be argued that even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established. The thing that is clearest is that the low Fed-mandated short-term interest rates make high valuations seem reasonable. When yields are low on fixed income instruments, low earnings yields on equities (that is, low e/p ratios, which equate to high p/e ratios) seem justified. As Buffett said in February, “Measured against interest rates, stocks actually are on the cheap side compared to historic valuations.” But he went on to say, “. . . the risk always is that interest rates go up a lot, and that brings stocks down.” Are you happy counting on continued low interest rates for your investment security, especially at a time when the Fed has embarked upon a series of rate increases? And if interest rates do remain low for several more years, isn’t it likely to be as a result of a lack of vigor in the economy, which would likely cause earnings growth to be sluggish? VIX The value of an option contract is largely a function of the volatility of the asset under option. For example, the owner of a “call” has the right – but not the obligation – to buy something at a fixed “strike price.

” Thus he should hope the asset will be volatile: if its price rises a lot, he can buy at the strike price and sell at the new, higher price, locking in a profit. And what if it goes down a lot? No matter; he isn’t obligated to buy. Thus the expected volatility of the underlying asset is a key ingredient in determining the proper price for an option. For example, everything else being equal, the more volatile an asset is expected to be, the more the buyer of a call should be willing to pay for it (since he participates in the gains but not the losses) and the more the seller of a call should charge for it (since he is forgoing upside potential but retaining downside risk). This is reflected through option-pricing formulas such as the Black-Scholes Model. The formulas can also be used backwards. Starting with the option price, you can figure out what level of volatility the buyers and sellers are anticipating. Thus, ever since 1990, the Chicago Board Options Exchange has published the CBOE Volatility Index, or “VIX,” showing how volatile investors in options on the S&P 500 expect it to be over the next 30 days. The attention paid to the VIX has increased in recent years, and it has come to be called the “complacency index” or the “investor fear gauge.” When the VIX is low, investors are pricing in stable, tranquil markets, and when it’s high they’re anticipating major ups and downs.

The bottom line is that last week’s VIX was the lowest in its 27-year history – matching a level seen only once before. The index was last this low when Bill Clinton took office in 1993, at a time when there was peace in the world, faster economic growth and a much smaller deficit. Should people really be as complacent now as they were then? What’s the significance of the VIX, anyway? Most importantly, it doesn’t say what volatility will be, only what investors think volatility will be. Thus it’s primarily an indicator of investor sentiment. In “Expert Opinion” I quoted Warren Buffett as having said, “Forecasts usually tell us © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: more of the forecaster than of the future.” In a similar way, the VIX tells us more about people’s mood today than it does about volatility tomorrow. All we really know is that implied volatility expectations are low today. As with most things in investing, the VIX can be subject to multiple interpretations. As Business Insider wrote on July 18: While alarmists may view this [low level of VIX] as a negative — a signal that complacency has made traders vulnerable to an unforeseen shock — many investors simply see it as a byproduct of conditions ideal for stocks to continue edging higher. I would add one last thing: people extrapolate. So when volatility has been low, they tend to assume it will be low and build that assumption into the prices for options and assets. The two are not the same. Super-Stocks Bull markets are often marked by the anointment of a single group of stocks as “the greatest,” and the attractive legend surrounding this group is among the factors that support the bull move. When taken to the extreme – as it invariably is – this phenomenon satisfies some of the elements in a boom listed on page four, including:  trust in a virtuous circle incapable of being interrupted;  conviction that, given the companies’ fundamental merit, there’s no price too high for their stocks; and  the willing suspension of disbelief that allows investors to extrapolate these positive views to infinity.

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?

Each deviation from the broad indices introduces definitional issues and non-passive, discretionary decisions. Passive funds that emphasize stocks reflecting specific factors are called “smart-beta funds,” but who can say the people setting their selection rules are any smarter than the active managers who are so disrespected these days? Bregman calls this “semantic investing,” meaning stocks are chosen on the basis of labels, not quantitative analysis. There are no absolute standards for which stocks represent many of the characteristics listed above. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage. Here’s what Barron’s had to say earlier this month: With cap-weighted indexes, index buyers have no discretion but to load up on stocks that are already overweight (and often pricey) and neglect those already underweight. That’s the opposite of buy low, sell high. The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced. Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold.

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.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Thus I would mostly do the things I always have done and accept that returns will be lower than they traditionally have been (#2). While doing the usual, I would increase the caution with which I do it (#3), even at the cost of a reduction in expected return. And I would emphasize “alpha markets” where hard work and skill might add to returns (#6), since there are no “beta markets” that offer generous returns today. These things are all embodied in our implementation of the mantra that has guided Oaktree in recent years: “move forward, but with caution.” Since the U.S. economy continues to bump along, growing moderately, there’s no reason to expect a recession anytime soon. As a consequence, it’s inappropriate to bet that a correction of high prices and pro-risk behavior will occur in the immediate future (but also, of course, that it won’t). Thus Oaktree is investing today wherever good investment opportunities arise, and we’re not afraid to be fully invested where there are enough of them. But we are employing caution, and since we’re a firm that thinks of itself as always being cautious, that means more caution than usual. This posture has served us extremely well in recent years.

” I much prefer Warren Buffett’s view: “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” For only the third time in history, emerging market debt is selling at yields below those on U.S. high yield bonds. Is Argentina, a country that defaulted five times in the last hundred years (and once in the last five), likely to get through the next hundred without a rerun? The essential bottom line in all investing is simple: is the risk premium at least adequate? Can we answer in the affirmative with regard to emerging market debt today? Private Equity In today’s low-return world, it’s clear that institutional investors needing 7-8% a year aren’t likely to get it from Treasurys yielding 1-2%, high grades at 3-4%, or mainstream stocks that most people expect to return 5-6%. Heck, you can’t even get it from Ivory Coast bonds! Where is one to turn? The good news for firms like Oaktree is that the answer is felt to most likely lie in what have come to be called “alternative investments” (there was no collective term for them when my partners and I started off 30 years ago). Since essentially no public “beta” markets offer the returns institutions need, many have turned instead to so-called “alpha strategies,” where skillful, active management has the potential to augment market returns, producing what’s needed.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Where are we today? As I said earlier, risk is high and prospective return is low, and the low prospective returns on safe investments are pushing people into taking risk – which they’re willing to do – at a time when the reward for doing so is low. Given my view of the environment, the only reason to be aggressive today is because defensive investing implies low prospective returns. But the question is whether pursuing high expected returns through aggressiveness can be counted on to be rewarded. If the answer is no, as I believe, then this is a time for caution. That doesn’t mean you have to be content with a low-return portfolio. If you need returns higher than those available in the beta markets at the low-risk end of the spectrum, it is reasonable to move into riskier asset classes. But for every asset class, there are high-risk and low-risk approaches. When the market is rational, low-risk investments will always appear to offer prospective returns lower than those on high-risk ones. But in tough times, the former are less likely to bring losses than the latter. In my opinion that makes them right for today. * * * Perhaps the best way to understand investment cycles is through that great statement attributed to Mark Twain: “History doesn’t repeat, but it does rhyme.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: medium” and rather little in the range of reasonableness. First there’s denial, and then there’s capitulation. The Sources of Error To explain why these bipolar episodes occur, I want to spend a little time on some of the factors behind investor psychology. For the most part they’re easily observed and dissected, and not mysterious. I discussed some of them in “It’s Not Easy”: Emotion is one of the investor’s greatest enemies. Fear makes it hard to remain optimistic about holdings whose prices are plummeting, just as envy makes it hard to refrain from buying the appreciating assets that everyone else is enjoying owning. Confidence is one of the key emotions, and I attribute a lot of the market’s recent volatility to a swing from too much of it a short while ago to too little more recently. The swing may [result] from disillusionment: it’s particularly painful when investors recognize that they know far less than they had thought about how the world works. It’s important to remain moderate as to confidence, but instead it’s usually the case that confidence – like other emotions – swings radically. While China was the “proximate cause” of the recent volatility, other things often contribute, and last month was no exception. The word that always comes to mind for me is “confluence.” Investors can usually keep their heads in the face of one negative.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Most mature investors know intellectually that short-term price fluctuations are low in fundamental significance, and that the best results will be achieved if they hold on to their positions and ride out the volatility. But sometimes people sell anyway, perhaps for the above reasons. Doing so has the potential to convert a short-term fluctuation into a permanent loss by causing any subsequent recovery to be missed. I consider this the cardinal sin in investing. What Do the Media Know? I’m usually able to find something in the print or broadcast media that helps me make my point. Here’s how The New York Times led the business section on Saturday: Concern Grows That Market Sell-off is an Early Warning of a U.S. Slowdown It may be time for everyone to take the markets seriously again. As stock prices started tumbling in the first trading days of the year, many Wall Street professionals were tempted to describe the declines as the sort of adjustment that the market has gone through in recent years before moving higher. But that opinion evaporated this week as the selling intensified. Concerns are now growing that the markets are signaling that the United States economy, despite its recent bright spots, is on the verge of a slowdown. The fear is that economic problems in China have set off negative reactions around the world that could ultimately weigh on American households and corporations.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: * * * I want to end by making one thing completely clear. I’m not saying the market is never right when prices go down (or up). I’m merely saying the market has no special insight and conveys no consistently helpful message. It’s not that it’s always wrong; it’s that there’s no reason to presume it’s right. It is the goal of some investors to sell on declines when the subsequent movements will be down, but “buy the dips” when the subsequent movements will be up. If you think you can tell which is which from watching the market movements themselves, then we – again – have a fundamental disagreement. Future price movements can only be predicted on the basis of the relationship between price and fundamentals. And, given the market’s short-term volatility and irrationality, this can only be done in the long-term sense. The market has nothing useful to contribute on this subject. January 19, 2016 © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

That fact leaves the investor to struggle in a complex, challenging environment. Recent Experience The recent volatility in the world’s markets, the S&P 500’s 11% drop between August 17 and 25, and the decline of nearly 40% in Chinese equities have given investors an opportunity to experience something else that’s not easy: portfolio management under adverse conditions. A few lessons are worth noting, none of which are always easy to employ:  Emotion is one of the investor’s greatest enemies. Fear makes it hard to remain optimistic about holdings whose prices are plummeting, just as envy makes it hard to refrain from buying the appreciating assets that everyone else is enjoying owning. As I mentioned just above, everyone is buffeted by the same influences and emotions. Superior investors may not be insulated, but they manage to act as if they are.  Confidence is one of the key emotions, and I attribute a lot of the market’s recent volatility to a swing from too much of it a short while ago to too little more recently. The swing may have resulted from disillusionment: it’s particularly painful when investors recognize that they know far less than they had thought about how the world works. In this case, when China’s growth slowed, its currency depreciated and its market corrected, I think a lot of investors realized they don’t know what the implications of these things are for the economies of the U.S. and the world.

© Oaktree Capital Management, L.P. All Rights Reserved Chinese investors who had bought stocks on margin and perhaps were experiencing their first serious market correction. Their selling prompted investors in the U.S. and elsewhere to sell also, believing that the market decline in China signaled serious implications for the Chinese economy and others. The analysis of fundamentals and valuation should dictate an investor’s behavior, not the actions of others. If you let the investing herd – which determines market movements – tell you what to do, how can you expect to outperform?  While China was the “proximate cause” of the volatility, other things often contribute, and last month was no exception. The word that always comes to mind for me is “confluence.” Investors can usually keep their heads in the face of one negative. But when they face more than one simultaneously, they often lose their cool. One additional negative last month was the glitch in Bank of New York Mellon’s SunGard software, and the bank’s consequent inability to price 1,200 mutual funds and ETFs that it administers. It was another dose of disillusionment: no one enjoys learning that the market mechanisms they need to work can’t be depended on.  In good times – perhaps emulating Warren Buffett – investors talk about how much they’d like to see the stocks they own decline in price, since it would allow them to add to positions at lower levels.

© Oaktree Capital Management, L.P. All Rights Reserved There may be absolutely no intellectual justification for that feeling. If you liked it a month ago at $80, should you sell it now just because it’s at $60? The best way to get through a downdraft is to verify your thesis, tighten your seatbelt and hang on. If you sell just because there’s a downdraft (or an updraft), you’ll never get that twenty-year winner. When you look closely, you’ll see that every twenty-year rise included a lot of ups and downs. To enjoy long-term success, you have to hold through them.  A lot has been written of late about reduced liquidity in the current investment environment, in part a result of restrictions under the Volcker rule. This may have contributed to last month’s volatility, but it should be viewed as having exacerbated the short-term pain, not as altering the long-term fundamentals. Coping with a declining market seems easy ahead of time, since emotions aren’t in play and investors know what they should do. It’s only when prices start falling in earnest, as they have recently, that it turns out to be harder than expected. So What Will Work? Superior investing isn’t easy. I’ve set forth a number of examples of its complexity, and a long list of simplistic rules that can’t be depended on. Among the many things that keep investing from being easy is the fact that no tactic works every time. Almost every tool an investor might employ is a two-edged sword.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Dare to Be Great II In September 2006, I wrote a memo entitled Dare to Be Great, with suggestions on how institutional investors might approach the goal of achieving superior investment results. I’ve had some additional thoughts on the matter since then, meaning it’s time to return to it. Since fewer people were reading my memos in those days, I’m going to start off repeating a bit of its content and go on from there. About a year ago, a sovereign wealth fund that’s an Oaktree client asked me to speak to their leadership group on the subject of what makes for a superior investing organization. I welcomed the opportunity. The first thing you have to do, I told them, is formulate an explicit investing creed. What do you believe in? What principles will underpin your process? The investing team and the people who review their performance have to be in agreement on questions like these:  Is the efficient market hypothesis relevant? Do efficient markets exist? Is it possible to “beat the market”? Which markets? To what extent?  Will you emphasize risk control or return maximization as the primary route to success (or do you think it’s possible to achieve both simultaneously)?  Will you put your faith in macro forecasts and adjust your portfolio based on what they say?  How do you think about risk? Is it volatility or the probability of permanent loss?

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Risk Revisited Again The operators of racetracks take a dim view of bettors who engage in “past-posting”: trying to get a bet down after the race is over (and the horses are “past the post”). In that vein, it’s been my practice not to rewrite old memos as new developments arise or new ideas strike me. However, while preparing “Risk Revisited” of September 2014 for inclusion in a compilation of my memos, I thought of a number of ways in which it could be made better. And since it was my original intention to have it contain everything I know about risk, I’ve decided to incorporate them. To make it clear which sections are new, I’ve put them in italics. In April 2014, I had good results with Dare to Be Great II, starting from the base established in an earlier memo (Dare to Be Great, September 2006) and adding new thoughts that had occurred to me in the intervening years. Also in 2006 I wrote Risk, my first memo devoted entirely to this key subject. My thinking continued to develop, causing me to dedicate three chapters to risk among the twenty in my book The Most Important Thing. This memo adds to what I’ve previously written on the topic. What Risk Really Means In the 2006 memo and in the book, I argued against the purported identity between volatility and risk. Volatility is the academic’s choice for defining and measuring risk.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Risk Revisited In April I had good results with Dare to Be Great II, starting from the base established in an earlier memo (Dare to Be Great, September 2006) and adding new thoughts that had occurred to me in the intervening years. Also in 2006 I wrote Risk, my first memo devoted entirely to this key subject. My thinking continued to develop, causing me to dedicate three chapters to risk among the twenty in my book The Most Important Thing. This memo adds to what I’ve previously written on the topic. What Risk Really Means In the 2006 memo and in the book, I argued against the purported identity between volatility and risk. Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory. In the book I called it “machinable,” and there is no substitute for the purposes of the calculations. However, while volatility is quantifiable and machinable – and can also be an indicator or symptom of riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility.

In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss. Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporary – doesn’t present a big problem if the investor is able to hold on and come out the other side. A permanent loss – from which there won’t be a rebound – can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss. Of course, the problem with defining risk as the possibility of permanent loss is that it lacks the very thing volatility offers: quantifiability. The probability of loss is no more measurable than the probability of rain. It can be modeled, and it can be estimated (and by experts pretty well), but it cannot be known. In Dare to Be Great II, I described the time I spent advising a sovereign wealth fund about how to organize for the next thirty years. My presentation was built significantly around my conviction that risk can’t be quantified a priori.

I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory. In the book I called it “machinable,” and there is no substitute for the purposes of the calculations. However, while volatility is quantifiable and machinable – and can be an indicator or symptom of riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss. Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporary – doesn’t present a big problem if the investor is able to hold on and come out the other side. A permanent loss – from which there won’t be a rebound – can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss.

Of course, the problem with defining risk as the possibility of permanent loss is that it lacks the very thing volatility offers: quantifiability. The probability of loss is no more measurable than the probability of rain. It can be modeled, and it can be estimated (and by experts pretty well), but it cannot be known. In Dare to Be Great II, I described the time I spent advising a sovereign wealth fund about how to organize for the next thirty years. My presentation was built significantly around my conviction that risk © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved as things aren’t worse than y and z,” but how can an absolute limit be specified? I wonder if the professor had anticipated that the S&P 500 could fall 57% in the global crisis. While writing the original memo on risk in 2006, an important thought came to me for the first time. Forget about a priori; if you define risk as anything other than volatility, it can’t be measured even after the fact. If you buy something for $10 and sell it a year later for $20, was it risky or not? The novice would say the profit proves it was safe, while the academic would say it was clearly risky, since the only way to make 100% in a year is by taking a lot of risk. I’d say it might have been a brilliant, safe investment that was sure to double or a risky dart throw that got lucky. If you make an investment in 2012, you’ll know in 2014 whether you lost money (and how much), but you won’t know whether it was a risky investment – that is, what the probability of loss was at the time you made it. To continue the analogy, it may rain tomorrow, or it may not, but nothing that happens tomorrow will tell you what the probability of rain was as of today. And the risk of rain is a very good analogue (although I’m sure not perfect) for the risk of loss. The Unknowable Future It seems most people in the prediction business think the future is knowable, and all they have to do is be among the ones who know it.

© Oaktree Capital Management, L.P. All Rights Reserved can’t be quantified a priori. Another of their advisors, a professor from a business school north of New York, insisted it can. This is something I prefer not to debate, especially with people who’re sure they have the answer but haven’t bet much money on it. One of the things the professor was sure could be quantified was the maximum a portfolio could fall under adverse circumstances. But how can this be so if we don’t know how adverse circumstances can be or how they will influence returns? We might say “the market probably won’t fall more than x% as long as things aren’t worse than y and z,” but how can an absolute limit be specified? I wonder if the professor had anticipated that the S&P 500 could fall 57% in the global crisis. While writing the original memo on risk in 2006, an important thought came to me for the first time. Forget about a priori; if you define risk as anything other than volatility, it can’t be measured even after the fact. If you buy something for $10 and sell it a year later for $20, was it risky or not? The novice would say the profit proves it was safe, while the academic would say it was clearly risky, since the only way to make 100% in a year is by taking a lot of risk. I’d say it might have been a brilliant, safe investment that was sure to double or a risky dart throw that got lucky.

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.

When you’re under pressure, the distinction between “volatility” and “loss” can seem only semantic. Volatility is not “the” definition of investment risk, as I said earlier, but it isn’t irrelevant. One example of a risk connected with volatility – or the deviation of price from what might be intrinsic value – is basis risk. Arbitrageurs customarily set up positions where they’re long one asset and short a related asset. The two assets are expected to move roughly in parallel, except that the one that’s slightly cheaper should make more money for the investor in the long run than the other loses, producing a small net gain with little risk. Because these trades are considered so low in risk, they’re often levered up to the sky. But sometimes the prices of the two assets diverge to an unexpected extent, and the equity invested in the trade evaporates. That unexpected divergence is basis risk, and it’s what happened to Long-Term Capital Management in 1998, one of the most famous meltdowns of all time. As Long-Term’s chairman John Meriwether said at the time, “the Fund added to its positions in anticipation of convergence, yet . . . the trades diverged dramatically.” This benign-sounding explanation was behind a collapse some thought capable of bringing down the global financial system. © 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.

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. When you’re under pressure, the distinction between “volatility” and “loss” can seem only semantic. Volatility is not “the” definition of investment risk, as I said earlier, but it isn’t irrelevant. One example of a risk connected with volatility – or the deviation of price from what might be intrinsic value – is basis risk. Arbitrageurs customarily set up positions where they’re long one asset and short a related asset. The two assets are expected to move roughly in parallel, except that the one that’s slightly cheaper should make more money for the investor in the long run than the other loses, producing a small net gain with little risk. Because these trades are considered so low in risk, they’re often levered up to the sky. But sometimes the prices of the two assets diverge to an unexpected extent, and the equity invested in the trade evaporates.

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.

Here are a few:  the importance of risk and risk control  the repetitiveness of behavior patterns and mistakes  the role of cycles and pendulums  the volatility of credit market conditions  the brevity of financial memory  the errors of the herd  the importance of gauging investor psychology  the desirability of contrarianism and counter-cyclicality  the futility of macro forecasting Most or all of these have to do with behavior that’s observed in the markets over and over. When I see it recur and want to comment, I’m often tempted to dust off an old memo, update the details, and just insert the word “ditto.” But I don’t, because there’s usually something worth adding. Cycles One of the most important themes in investing – and one I often find worthy of discussion – relates to cycles. What is a cycle? Dictionaries define it as “a series of events that are regularly repeated in the same order” or “any complete round or series of occurrences that repeats or is repeated.” And here’s the definition of the term “business cycle”: “The recurring and fluctuating levels of economic activity that an economy experiences over a long period of time.” © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

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.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. The Realities of Risk and Return In late 2008 and early 2009 (in other words, for universities, fiscal year 2009), the global financial crisis presented the greatest sinkhole in eighty years. Those caught mid-stream without life jackets were penalized. Many of Penn’s leading peer institutions lost 25-28% that year, while Penn’s loss was “only” 15½%. I described Penn’s results, loosely speaking, as “the least worst.” Going from the investment arena to the real world of university operations makes it clear that investment risk isn’t an abstraction. No, risk isn’t just volatility. It’s what happens to owners of capital when downward fluctuations occur and principal losses are experienced. Many of Penn’s peers were forced to curtail some of their spending, ranging from hot breakfasts to student aid. Some had to suspend construction projects. There were freezes on hiring and wages. Some put illiquid partnership interests up for sale to raise cash and/or escape continuing funding obligations. And some had to borrow in the taxable bond market to meet cash needs. Penn, on the other hand, had lots of liquidity and faced little in the way of capital calls. Thus it didn’t have to go on the defensive operationally. Instead, it was able to keep hiring faculty, keep giving grants instead of loans, and take advantage of an attractive opportunity to purchase adjacent acreage. The benefits of risk control were made concrete.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Memo to: Oaktree Clients From: Howard Marks Re: What’s Behind the Downturn? In May, I observed in “How Quickly They Forget” that investors had returned to pro-risk behavior despite the lingering presence of significant macro worries. And then just three months later, a number of exogenous events caused the markets to undergo a significant decline and one of the greatest paroxysms of volatility ever seen. All of the reasons existed well before. Investors simply hadn’t taken them to heart. I never cease to marvel, and complain, about the way investors flip-flop – focusing on just the positives at one moment and just the negatives at another – and the speed at which they do it. But I learned long ago not to be surprised by this phenomenon or expect it to stop occurring, but instead to look past the market’s behavior and assess the underlying realities. Thus I decided to take the occasion of my summer vacation to write a memo parsing the recent events and touching on the outlook. Confluence Markets usually do a pretty good job of coping with problems one at a time. When one arises, analysts analyze and investors reach conclusions and calmly adjust their portfolios. But when there’s a confluence of negative events, the markets can become overwhelmed and lose their cool. Things that might be tolerable individually combine into an unfathomable mess whose extent and ramifications seem beyond analysis.

However:  none of these is a new development; they all existed three or six months ago, when the markets were sanguine,  their scariness is due to the fact that many are relatively unprecedented, and thus the solutions aren’t obvious or time-tested, and  this uncertainty is among the greatest contributors to the markets’ unease. So, as is often the case, the swing we’ve had is more in psychology than in fundamentals. The positives of June are diminished, forgotten or eclipsed, and now investors are preoccupied with the negatives. As usual, the truth probably lies in between. We face a new world nowadays in terms of the speed of media coverage, the vast number of outlets competing for people’s attention, and in many cases their seeming lack of concern over their own partiality, volatility and non-objectivity. I have no doubt that the media contribute significantly to the manic swing from “it’s all good” to “it’s all bad,” with its highly unsettling effect on the markets. Emotion takes over from reason. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Bonds used to constitute the majority of portfolios; then a 70:30 equity/bond mix became the norm; and then bonds went further out of style. And then, when bond allocations got as small as they could, the style mavens began to call for more, instead. Of course it helped that bonds outperformed during and after the crisis. So few people held bonds going into the crisis, and in such small amounts, that the attractions of bonds must seem like a sudden revelation: They’re senior in the capitalization to equities, of course, so they’re less subject to fundamental risk. Then there’s what I call the “power of the coupon.” In addition to redemption at maturity, most bonds provide an interest check every six months. Not only are these cash flows spendable and investable, but they also serve to stabilize bond prices, restraining volatility. Sounds like a great deal. So why, people now wonder, did we hold so few? Take historically small allocations, add in newly discovered merits, and you get a buying trend and rising prices. The fundamental underpinnings for the buying trend in bonds are the converse of those compelling equity reductions: concern about economic sluggishness, the chance for a double dip, and even the distant possibility of deflation.

against volatility, with the CBOE Vix index down to its lowest since the crisis eve of July 2007, and in sharp reductions in cash cushions held by institutions. Merrill Lynch’s widely followed survey of fund managers . . . finds that more now want companies to pay higher dividends or make more capital expenditures than see them pay down debts. . . . Such equanimity is not totally irrational. Macroeconomic data in the past month have run ahead of expectations. When the herd trampling forward is this bullish, it is not a good idea to stand in its way. But it would be easier to feel comfortable with current share price levels if investors showed a little more unease. Complacency on this scale suggests risk of a correction. (“Investor sentiment,” Financial Times, April 14) Just as one returning swallow doesn’t make a summer, anecdotal evidence of rising risk tolerance does not mean entire markets have returned to dangerous levels. But it’s a fact that issuers and investment bankers can do things today that they couldn’t do a year or two ago. The door is open to transactions that wouldn’t be possible if risk aversion were running high. The clear inference is that fear of loss has declined and fear of missed opportunity has come back to life. That’s an important observation. Where Did the Unease Go? Just a short while ago, I believed investors had been sufficiently traumatized that the willingness to bear risk would be absent for years. But it came back in just a matter of months.

© Oaktree Capital Management, L.P. All Rights Reserved  Quant investing arrived, too, achieving its first real fame with the success of Long- Term Capital Management. This Nobel Prize-laden firm used computer models to identify fixed income arbitrage opportunities. Like most other investment miracles, it worked until it didn’t. Thanks to its use of enormous leverage, LTCM melted down spectacularly in 1998.  Investors’ real interest in the last half of the ’90s was in common stocks, with the frenzy accelerating but narrowing to tech-media-telecom stocks around 1997 and narrowing further to Internet stocks in 1999. The “limitless potential” of these instruments was debunked in 2000, and the equity market went into its first three-year decline since the Great Crash of ’29.  Venture capital funds, blessed with triple-digit returns thanks to the fevered appetite for tech stocks, soared in the late 1990s and crashed soon thereafter.  After their three-year slump, the loss of faith in common stocks caused investors to shift their hopes to hedge funds – “absolute return” vehicles expected to make money regardless of what went on in the world.  With the bifurcation of strategies and managers into “beta-based” (market-driven) and “alpha-based” (skill-driven), investors concluded they could identify managers capable of alpha investing, emphasize it, perhaps synthesize it, and “port” or carry it to their portfolios in additive combinations.

Likewise, a fatally flawed investment product can easily survive until it’s tested in a bear market. The extensive investment innovation of 2003-07 was driven by the poor performance of stocks in 2000-02 and the low yields available on high grade bonds. A large number of new products and strategies emerged, increasing in popularity in a salutary environment. Few investors were troubled by the products’ dependence on high leverage or suddenly commonplace triple-A ratings, or by the fact that they hadn’t been tested in tough times. It’s not surprising that bull market developments were defrocked in the tougher times of 2007- 08, but it’s somewhat shocking how many examples there are. It turned out that:  losses on investments involving leverage, illiquidity or risky assets could be much worse than the “worst case” that had been predicted,  beta had been confused for alpha, just as leverage had for value added,  there was nothing absolute about “absolute return,” and “market neutral” strategies were correlated with the market,  the “golden age of private equity” had been a function of easy money, not bargain purchases,  sharing the upside with investment managers isn’t sufficient to align their interests with those of their clients, and  things that “should happen” often don’t. While an extreme case, the story of Bernie Madoff presents an apt example of this phenomenon.

 Thus, incentive fee arrangements should be exceptional, but they’re not. These fees didn’t go to just the proven managers (or the ones whose returns came from skill rather than beta); they went to everyone. If you raised your hand in 2003-07 and said “I’m a hedge fund manager,” you got a few billion to manage at two-and-twenty, even if you didn’t have a record of successfully managing money over periods that included tough times.  The run-of-the-mill manager’s ease of obtaining incentive fees was enhanced each time a top manager capped a fund. As I wrote in “Safety First . . . But Where?” (April 2001), “When the best are closed, the rest will get funded.”  In fact, whereas two-and-twenty was unheard-of in the old days, it became the norm in 2003-07. This enabled a handful of managers with truly outstanding records to demand profit shares ranging up to 50%.  Clients erred in using the term “alignment of interests” to describe the effect of incentive compensation on their relationships with managers. Allowing managers to share in the upside can bring forth best efforts, but it can also encourage risk bearing instead of risk consciousness. Most managers just don’t have enough money to invest in their funds such that loss of it could fully balance their potential fees and upside participation.viewed

© Oaktree Capital Management, L.P. All Rights Reserved Investors pulled a record $72 billion from stock funds overall in October alone . . . . If history is any guide, they may not return quickly. I want to make a heretical assertion: that equities aren’t the greatest thing since sliced bread, but rather an asset class that can do well or poorly depending on how it’s priced. Investors fell into a trap at the 1999 peak because they were seduced by stocks’ long-term average return in addition to their recent gains. Rather than ask “What’s been the historic return on stocks?” they should have asked “What’s been the historic return on stocks if you bought them when the average p/e ratio was 29 (which it was at the time)?” Once again, investors came to believe in the magic asset class and forgot the importance of reasonable valuation. The truth is, rather than being superior, equities are an inferior asset class . . . structurally, that is. Unlike debt, they don’t promise annual interest or repayment at maturity, and they don’t carry a senior claim against the company’s assets in case of trouble. All they offer is an uncapped participation in profits. Debt promises a stream of contractual payments, and common stocks provide the residual that remains after those payments have been made. Thus equities’ higher historic average and potential future returns should be viewed as nothing more than compensation for their inferior status and greater volatility.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Volatility + Leverage = Dynamite Nearly fifteen years ago, in April 1994 – at a time when absolutely no one was reading my memos – I published one called “Risk in Today’s Markets Revisited.” That’s when I first proposed the formula shown above. I recycled it in “Genius Isn’t Enough,” on the subject of Long-Term Capital Management (October 1998). The last few years have provided a great demonstration of how dangerous it can be to combine leverage with risky assets, and that’s the subject of this memo. It’ll also pick up on some ideas from my last memo, “The Limits to Negativism.” My memo “Plan B” on the bailout proposal went out on September 24, and as I lay in bed later that night, I realized that I hadn’t taken one part of it nearly far enough. In discussing a prime cause of the credit crisis, I wrote the following: I’ll keep it simple. Suppose you have $1 million in equity capital. You borrow $29 million and buy $30 million of mortgage loans. Twenty percent (or $6 million) of the mortgages go into default, and the recovery on them turns out to be only two-thirds ($4 million). Thus you’ve lost $2 million . . . your equity capital twice over. Now you have equity capital of minus $1 million, with assets of $28 million and debt of $29 million.

When Hedge Fund P got its margin call and its portfolio was sold out, that forced securities prices downward. So Fund Q – which holds many of the same positions – also receives a margin call, perpetuating the downward spiral and bringing more losses to more institutions. All of these scenarios, and many others, are connected by a common thread: the combination of leverage and illusory safety, which allowed institutions to take on too much risk for the amount of capital they had. First, it should be clear from the above that the amount of borrowed money – leverage – that it’s prudent to use is purely a function of the riskiness and volatility of the assets it’s used to purchase. The more stable the assets, the more leverage it’s safe to use. Riskier assets, less leverage. It’s that simple. One of the main reasons for the problem today at financial institutions is that they underestimated the risk inherent in assets such as home mortgages and, as a result, bought too much mortgage-backed paper with too much borrowed money. Let’s go back to the paragraph on page one. Here it is again: I’ll keep it simple. Suppose you have $1 million in equity capital. You borrow $29 million and buy $30 million of mortgage loans. Twenty percent (or $6 million) of the mortgages go into default, and the recovery on them turns out to be only two-thirds ($4 million).$2

© Oaktree Capital Management, L.P. All Rights Reserved Now let’s combine the two concepts. The bottom line is that in order for a company to avoid insolvency, its financial structure has to be such that its value won’t fall through the equity and into the debt. In naïve and far-from-technically correct terms, when the amount of debt exceeds the value of the company, it’s insolvent, as suggested below. What the following doodles illustrate is that for every level of riskiness and volatility, there’s an appropriate limit on leverage in the capital structure.

Certainly there’s every reason to believe that:  Assets are being valued based on what people will pay for them (which is the goal), but with few people in a buying mood, market prices can far understate value.  Supply and demand have completely supplanted fundamentals in determining prices.  With little trading taking place, assets are often priced via reference to indices. But those indices fluctuate wildly in connection with speculation and hedging activity, and they may have little relevance to the individual asset being priced.  Lenders are switching their valuations of collateral from going concern basis to liquidation basis.  Margin calls are resulting in liquidations, which depress prices, leading to more margin calls. It’s hard to believe these are really the bases on which financial institutions should value their trillion-dollar balance sheets. But we’re stuck for now with mark-to- market accounting. At minimum, you should expect it to contribute extensively to continued volatility. Believe me, it already has. “Should” ≠ “Will” Lately I’ve enjoyed comparisons of recent developments to Frankenstein’s loss of control over his monster, or to a man-made mutation that has escaped from the laboratory. Extensive financial sector experimentation took place involving unprecedented combinations of volatile elements such as leverage, securitization, tranching, derivatives © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

There’s an ongoing dilemma, as expressed in a joke I posted on my bulletin board in 1970, about the fact that analysts know a great deal about a few things, while portfolio managers know a little bit about a lot of things. In my view, however, risk managers know the littlest bit about the most things, so they’re least suited to evaluate portfolio risk. In December’s “No Different this Time,” I included a discussion of the leading risk modeling tool, “value at risk” or VaR, which provides a “worst case” estimate of the risk in a portfolio. I mentioned that in the first nine years after the model was adopted, its predicted maximum trading loss was never exceeded. And then, in the third quarter of 2007, it was exceeded on a quarter of the trading days. TSo clearly, this model proved to be less than totally reliable. The model may be flawed, the historic data on which it was based may have been non-representative or insufficient, or the world may have changed. Regardless of the reason, VaR failed. When you read about Goldman Sachs’s success in avoiding the CDO turmoil and getting net-short, (see The Wall Street Journal of December 14), you see it was done on the basis of the reasoned judgment of executives on its proprietary trading desk. Ironically, when mortgage-related security prices first began to plummet, the increase in volatility raised Goldman’s VaR, causing the elimination of positions that eventually would have been highly profitable.

Given the above, what was the credit quality of subprime mortgages? I’d say double-B at best. (I’d much rather buy even the single-B “junk bonds” of profitable companies that we’ve held over the last 30 years than this inflated “home option” paper.) And yet, in a typical CDO, 80% of the debt was rated triple-A and 97% was rated investment grade (triple-B or better). Those high ratings made CDO debt very attractive to financial institutions that were able to borrow cheaply to buy high-rated assets, satisfying the strict rules regarding the “quality” of their portfolio holdings. Financial engineers and investment bankers took unreliable collateral and packaged it into highly leveraged structures supporting debt that was rated high enough to attract financial institutions. What a superb example of the imprudent use of leverage. And what a simple explanation of how our highly leveraged institutions got into trouble. UHow Bad is Bad? One of the prime lessons that must be learned from this experience is that in determining how much leverage to put on, you’d better make generous assumptions about how risky your assets might turn out to be. The example in the paragraph on page one demonstrates the role of risk in the equation. The more your assets are prone to permanent loss, the less leverage you should employ. But it’s also important to recognize the role of volatility.the

© Oaktree Capital Management, L.P. All Rights Reserved lenders can cut off credit, (b) investors can be frightened into withdrawing their equity, or (c) the violation of regulatory or contractual standards can trigger forced selling. The problem is that extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen – that assumptions regarding risk were too conservative. Thus it becomes tempting to relax rules and increase leverage. And often this is done just before the risk finally rears its head. As Nassim Nicholas Taleb wrote in Fooled by Randomness: Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security . . . Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. . . . One is thus capable of unwittingly playing Russian roulette – and calling it by some alter- native “low risk” name. (p. 28; emphasis added) The financial institutions played a high-risk game thinking it was a low-risk game, all because their assumptions on losses and volatility were too low.

you end up with something that has a higher expected return but isn’t riskier? That’s too good to be true.  Finally, in addition to magnifying losses as well as gains, leverage carries an extra risk on the downside that isn’t offset by accompanying upside: the risk of ruin. Leverage, when added to losses, can lead to margin calls and meltdowns. There is no corresponding benefit. This lesson is being well learned today. Second, every investment or portfolio entails a variety of risks, and its overall risk is the sum of those. Every investment embodies both the specific risk related to the individual company or asset and the systematic risk that is a function of its membership in a market – its beta. There also can be liquidity risk, legal risk, currency risk and political risk. Finally, risk is introduced by the structure in which an asset is held. Here I’m referring to the risk that comes with leverage. To simplify for my current purpose, risk comes from the combination of what you buy and how you finance it. You can buy very risky assets, but if you don’t lever up to do so, you’ll never lose them to a margin call. Or you can buy fundamentally safe assets, but the combination of enough leverage and a sufficiently hostile environment can cause a meltdown. In other words, investing in “safe” assets isn’t necessarily safe, particularly if you’ve borrowed to buy them. We’ve seen this at work in recent days, as entities that invested in top-quality assets have run into trouble.

© Oaktree Capital Management, L.P. All Rights Reserved Consider these tales from the front lines:  There had never been a national decline in home prices, but now the Case-Shiller index is down 26% from its peak in July 2006, according to the Financial Times of November 29.  In my twenty-nine previous years with high yield bonds, including four when more than 10% of all outstanding bonds defaulted, the index’s worst yearly decline was 7%. But in 2008, it’s down 30% (even though the last-twelve-months’ default rate is only about 3%).  Performing bank loans never traded much below par in the past, and holders received very substantial recoveries on any that defaulted. Now, even though there have been few defaults, the price of the average loan is in the 60s. The headlines are full of entities that have seen massive losses, and perhaps meltdowns, because they bought assets using leverage. Going back to the diagrams on pages 4-5, these investors put on leverage that might have been appropriate with moderate-volatility assets and ran into the greatest volatility ever seen. It’s easy to say they made a mistake. But is it reasonable to expect them to have girded for unique events? If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year, it’s possible no leverage would ever be used. Is that a reasonable reaction? (In fact, it’s possible that no one would ever invest in these asset classes, even on an unlevered basis.)

For example, Carlyle Capital Corp. (“CCC”) invested in AAA-rated debt of the two government-sponsored housing agencies, Freddie Mac and Fannie Mae. But it levered its equity 31 times to do so, buying $21.7 billion of securities on the basis of just $670 million of equity. That meant that if values declined 3%, its equity would be gone. Worried bankers pulled back their loans; CCC received margin calls it couldn’t meet; the banks seized its assets; and the fund melted down. Investment safety doesn’t come from doing safe things, but from doing things safely. Put another way, anything can be screwed up by using so much leverage that its fluctuations can’t be survived. That’s why, in writing about LTCM in “Genius Isn’t Enough” (January 1999), I said leverage + volatility = dynamite. Financial Self-Destruction The dramatic cyclical up leg of nearly five years (I’d say November 2002 through June 2007), as well as the far shorter but equally dramatic down leg that started last summer, have given me opportunity to reflect on a number of phenomena to be noted and lessons to be learned. You’ve seen the results in the last three memos (“No Different This Time,” “Now What?” and “Whodunit”). I’ve reached a new view of how some things work, based on tying together several separate observations. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved  Alt-A mortgages – not subprime, but similarly weak on documentation,  mortgage lenders,  commercial mortgage-backed securities, not because rents or property values are down, but because these securities may be held by residential mortgage investors forced to raise cash,  bridge financings – and with them the likelihood of future buyouts looking anything like those of the recent past,  the investment and commercial banks that committed to the bridges,  the stocks of target companies in announced buyouts that are shaky as to completion and/or likely to be renegotiated,  merger arbitrageurs, or “risk arbs,” who assumed the risk of these deals failing to be consummated as announced,  others who bet that good times and low volatility would continue, and that probable things would happen and improbable things wouldn’t. These include sellers of put options and credit default insurance,  “quant firms” that built highly leveraged portfolios with help from models that extrapolated past market behavior,  hedge funds and other leveraged investors in a wide variety of fields that pursued “spread” or “carry” trades using large amounts of borrowed money (more on this later),  banks (e.g., Germany’s IKB) and fund managers (e.g.

© Oaktree Capital Management, L.P. All Rights Reserved A system designed to distribute and absorb risk might, instead, have bred it, by making it so easy for investors to buy complex securities they didn’t fully understand. (The Wall Street Journal, August 7) [Loans] are now often bundled into securities that are sold in pieces to investors around the world, changing hands many times. It spreads risk, which policy makers believe keeps the overall financial system sound and stable. But the downside to this system could be serious. (WSJ, August 10) “The market appears to be finding it harder to truly understand the inherent and underlying risks involved,” [according to Chris Rexworthy, a former regulator with Britain’s FSA]. The backlash is particularly sharp abroad, in countries that were surprised to find that problems with United States homeowners could be felt so keenly in their home markets. (New York Times, August 31) “Low volatility has created complacency, and that has translated into poorly structured derivative markets,” says Randall Dodd, director of the Financial Policy Forum . . . The low volatility world of the past few years may have worsened the situation, leading to lax lending standards for derivative investors. (WSJ, August 2) It is estimated that there are seven times as many credit derivatives outstanding as there are outstanding bonds. You need to ask the question: is risk being transferred or created?

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Risk The reading materials for a meeting of a corporate board on which I sit – and what turned out to be an eight-hour meeting of the audit committee (thank you, Messrs. Sarbanes and Oxley) – included an article by Rick Funston, a Principal of Deloitte & Touche LLP and its National Practice Leader for Governance and Risk Oversight. The subject of the article was corporate risk, but many of its points were equally applicable to investment risk. It got me thinking. We’re all preoccupied with the quest for excellent investment returns, and most of us understand that risk management has a lot to do with achieving them. From there, investment orthodoxy often takes over, with the discussion turning to the relationship between return and volatility. But I think that tells so little of the story that I’ve decided to devote an entire memo to the subject of risk. 0BUWhy Does Risk Matter? When I joined the investment management industry at the tail end of the 1960s, everyone talked about returns but few people talked about risk-adjusted returns, or the idea that risk matters. I was fortunate, however, to have attended the University of Chicago in the preceding years, during which Capital Market Theory had begun to be discussed. Of course, nothing underlies the Capital Market approach as much as the relationship between risk and return.

© Oaktree Capital Management, L.P. All Rights Reserved Riskier investments are those where the outcome is less certain. That is, the probability distribution of returns is wider. When priced fairly, riskier investments should entail:  higher expected returns,  the possibility of lower returns, and  in some cases the possibility of losses. The traditional graph shown first above is deceptive, because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money. I hope my version of the graph is more helpful. It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and the possibility of loss increase as risk increases. 1BUWhat Is Risk? According to the academicians who developed Capital Market Theory, risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk. It’s my view that – knowingly or unknowingly – academicians settled on volatility as the proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not.

The problem with all of this, however, is that I just don’t think volatility is the risk most investors care about. There are many kinds of risk, and I’ll discuss some of them below. But volatility may be the least relevant of them all. Theory says investors demand more return from investments that are more volatile. But for the market to set the prices for investments such that more volatile investments will appear likely to produce higher returns, there have to be people demanding that relationship, and I haven’t met them yet. I’ve never heard anyone at Oaktree – or anywhere else, for that matter – say, “I won’t buy it, because its price might show big fluctuations,” or “I won’t buy it, because it might have a down quarter.” Thus it’s hard for me to believe volatility is the risk investors factor in when setting prices and prospective returns. In addition, volatility has a number of shortcomings that aren’t often addressed in the literature but are obvious to investment practitioners:  A stock that meanders from $50 to $80 is likely to have the same statistical volatility as one that goes from $50 to $20. However, most of us would have trouble saying that proves the former was as risky as the latter.

© Oaktree Capital Management, L.P. All Rights Reserved When one of the investment committees I’m on decided to increase the portfolio’s commitment to “absolute-return hedge funds” several years ago, the general consensus was that we wanted funds that would reliably deliver 9-10% or so. We wouldn’t expect to do much worse regardless of how badly the markets performed, and we wouldn’t be surprised if we failed to do much better when the markets rose. In other words: a steady, healthy return (implying good relative performance in bad times), but consequently with the likelihood of lagging the markets when they do well. Raise your hand if you agree. But problems arise. Most hedge funds do better in good years than bad, implying that they’re not really insensitive to market developments. Most hedge fund managers would acknowledge that their returns are derived from a combination of beta and alpha (that is, from market return plus the skill they bring to the investment process). And as long as beta plays a meaningful part, an investment’s return can’t really be described as “absolute.” Waring and Siegel argue that there’s no such thing as absolute investing, in that the alpha it aims to capture arises from relative decisions that are the basis for all active management.

© Oaktree Capital Management, L.P. All Rights Reserved  A stock that over a few years goes from $20 to $80 in a straight line will be described as low in risk, but if it suddenly declines from $80 to $50 it will be said to have become more risky. It’s hard to think of a given stock as riskier at $50 than it was shortly before at $80.  Generally, those who equate volatility with risk look to the historic volatility of an asset as the indicator of its future risk. But most of us know the future will not necessarily be like the past. And one good way to add value in the investment process is by predicting changes in riskiness, whereas no value is ever added through extrapolation. For all of these reasons, I find it hard to accept volatility as a comprehensive, sufficient or highly useful measure of risk. 2BUIf Not Volatility, Then What? Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return. To me, “I need more upside potential because I’m afraid I could lose money” makes an awful lot more sense than “I need more upside potential because I’m afraid the price may fluctuate.” No, I’m sure “risk” is – first and foremost – the likelihood of losing money. There are other kinds of risk, most of which affect each of us differently.

By this they mean that active management consists of trying to overweight (in relative terms) the things in a benchmark or market that will do better and underweight the things that will do worse, and by having more exposure to the benchmark or market in good times and less in bad times. These, they argue, are relative investing decisions. No wonder we could not sensibly define absolute-return investing: There is no such thing. The term is intended to capture investor attention by offering an intuitively appealing alternative to the disciplines required by relative-return investing, but at the end of the day it delivers beta returns plus or minus relative (alpha) returns . . . It may appear to be a distinct type of investing, but if there is a distinction, it is a distinction without a difference. I think Waring and Siegel go too far, and some of this feels like wordplay. You can call trying to buy the good and avoid the bad “relative investing,” because the decisions are made relative to the makeup of a market or benchmark. And it’s true, as Sid Cottle (of Graham, Dodd and Cottle) put it to me thirty years ago, that “investment is the discipline of relative selection.” But “relative” is just a word. The quest for better portfolios doesn’t necessarily make all active investors “relative investors” in the index-centric sense of the term. Waring and Siegel insist “the notion that every return has a beta component and an alpha component applies to any portfolio.

” And as they describe Bill Sharpe as saying, “The return on any, repeat any, portfolio consists of a market part and a nonmarket part.” However, there are investors and funds whose goal it is to buy the good and avoid the bad and, Uat the same timeU, to minimize the effect of general market fluctuations on their returns. They want to bring that beta term as close as possible to zero, and some are able to pull it off – more or less. So I think “absolute return” is a relative term, not – pardon me – an absolute one. But it’s still potentially useful.the

© Oaktree Capital Management, L.P. All Rights Reserved UUp-and-down UDown-and-up (total return %) U1999 U2000 U2002 U2003 Hedge Fund Average 23.4% 4.8% 3.0% 15.4% Long/Short Equity Avg 47.2 2.1 -1.6 17.3 S&P 500 21.0 -9.1 -22.1 28.7 Investors were glad to be in these funds rather than the S&P 500, as the returns were much steadier for the hedge funds than for the market and higher overall. But does the fact that losses were minimized or avoided in the down years mean that hedge funds provide absolute returns? That depends on your criteria for “absolute.” If “insensitive to market movements” or “free of external references or relationships” are among them, they do not meet the standard. According to The New Yorker of May 22, 2006, “A recent paper by the economists Burton Malkiel and Atanu Saha . . . showed that the range of performance among hedge-fund managers was much wider than among mutual-fund managers . . .” And Dow Jones estimates that the average equity long/short hedge fund lost 5% last month. So not consistent from fund to fund, and not consistent over time. Finally, research has shown that significant beta exposure is embedded in many hedge funds. In the spring 2004 Canadian Investment Review, Dominic Clermont of TD Asset Management reported the following findings: Over the 1994-2000 period, the aggregate hedge fund index had a market exposure (beta) of 0.37. Thus, on average, a significant portion of hedge fund managers’ returns came from market exposure.

Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom. Concern over this risk keeps many people from superior results, but it also creates opportunities in unorthodox investments for those who dare to be different.  Illiquidity – If an investor needs money with which to pay for surgery in three months or buy a home in a year, he may be unable to make an investment that can’t be counted on for liquidity that meets his schedule. Thus, for him, risk isn’t just losing money or volatility, or any of the above. It’s being unable when needed to turn an investment into cash at a reasonable price. This, too, is a personal risk. Theoretically, a fund whose life is perpetual and whose liquidity needs are predictable shouldn’t be sensitive to this risk and thus should be able to bear it for profit. The bottom line is that investment risk comes in many forms. Many risks matter to some investors but not to others, and they may make a given investment seem safe for some investors but risky for others. Rejecting risk as synonymous with volatility, as I do, eliminates the one measure of risk that’s entirely quantifiable, objective and absolute. This, in turn, makes it hard to argue that the market’s an efficient machine that precisely assesses the risk of each investment and allocates prospective return proportionately.

Some hedge fund strategies, such as emerging market hedge funds, had a much higher beta of 0.74. These observations certainly call into question the absoluteness of hedge fund performance. U What Do Investors Want? That’s a trick question, because the answer is usually heavily reliant on investors’ recent experience. When market performance has been good, they want participation going forward. But when performance has been bad, they demand protection. An endowment portfolio that delivered 15% per year in the late 1990s was described as disappointing, because many others made 20%-plus. But a portfolio that made 2% in the first few years of this decade was lauded, because most lost money. So people can feel good about 2% and bad about 15%. That’s human nature for you (and it shows why things other than absolute return matter . . . and perhaps why “common sense” is such an oxymoron). It also shows how danger creeps into markets. When everything’s been going swimmingly, investors forget about risk and want a full ride on the bandwagon. Seldom do they express concern about the fact that good past performance implies elevated asset prices, and maybe low returns and high risk going forward.investors

” While there’s no surefire route to investment success, I do believe one of the easiest ways to make money is by buying things whose merits others haven’t yet discovered. You ask, “When do you get that chance?” Not often, (and certainly not easily today), but not never. In 1978, Bache asked Citibank to manage a new mutual fund for it. Citibank turned the job over to me: “There’s some guy named Milken or something who works for a small brokerage firm in California, issuing and trading high yield bonds. Can you find out what that means?” Few people had ever heard of high yield bonds. There wasn’t much historic performance data, and what little there was came from a few obscure mutual funds. Buying bonds with a meaningful probability of default certainly seemed imprudent. Most institutional portfolios had an inviolate minimum credit rating for bonds of single-A or triple-B. Corporate CEOs said, “My buddy’s company was just threatened by a corporate raider backed by junk bonds; our pension fund will never own any!” And no public or union pension trustee wanted the headline risk associated with bankruptcy. In other words, the perfect buying opportunity. Thus, our high yield bond portfolios have outperformed high grade bonds for two decades-plus, by more than enough to compensate for their defaults, volatility and illiquidity. It’s been a long- term free lunch, and the earliest investors got the biggest helping.

 If we can just accomplish these two goals – market performance (or a bit better) in good times and highly superior performance in bad times – we’ll end up with above average performance over full cycles; below average volatility; outperformance in tough times (when it really matters); enough resolve to be able to resist selling out at cyclical lows; and a favorable investing experience overall.

© Oaktree Capital Management, L.P. All Rights Reserved How much risk did my manager take in order to generate that?” No, in the investment world few people find high returns worrisome. TEveryone talks about beta, (which I’m tempted to pronounce “bee-tah” now that I’ve spent six weeks in London), but few people dwell on it when returns are soaring. Credulous investors think the manager who generated 20% in an up-10% market contributed alpha of 10%. But maybe he had zero alpha and a beta of 2 instead . . . or maybe negative alpha of 20% and a beta of 4. Regardless, I almost never hear people talk about returns being so high that they’re suspect. According to Hillary Till of Premia Capital Management (in her report on Amaranth published by France’s EDHEC Business School), “Since May, investors knew [Amaranth’s] energy portfolio had typical up or down months of about 11%. . . . Therefore, it would not have been unusual for the fund’s energy trades to lose 24% in a single month. . . .” But nobody seemed to care, since the energy book gained $2 billion in just the first four months of 2006. In other words, Amaranth had enjoyed the up months. That certainly didn’t imply that down months weren’t lurking. In fact, just the opposite. THere’s the most important thing: My wife Nancy often quotes a few lines from Rudyard Kipling’s poem, “If”: TIf you can meet with Triumph and Disaster TAnd treat those two Impostors just the same; . . .

When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reason? These are the people Taleb calls “lucky idiots,” and in the short run it’s certainly hard to tell them from skilled investors. The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed. Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa. With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)? And ditto for a loser: how do we ascertain whether it was a reasonable but ill- fated venture, or just a wild stab that deserved to be punished? Did the investor do a good job of assessing the risk entailed? That’s another good question that’s hard to answer. Need a model? Think of the weatherman. He says there’s a 70% chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than zero and 100 except over a very large number of trials. The celebrated investor is one whose actions yielded good results. Was she lucky or good? How much risk did she take?

There simply is no cookie-cutter method – no single calculation – that considers them all.  The internal rate of return,  The times-capital-returned,  The percentage of the capital that was put to work,  The speed at which that capital was put to work,  When investments were harvested and distributions made,  What the LPs were able to do with capital that remained uncalled and/or was returned,  What the LPs could have done with the capital that was called and/or not returned. Finally, it’s important – as in all other areas of investing – to consider how much risk a fund took to earn its return. We’ve become accustomed to evaluating managers of public securities on the basis of risk-adjusted returns, but this approach hasn’t equally reached the alternative markets. Part of this is because alternative assets generally haven’t been marked to market, and thus there are no meaningful figures for volatility (without those simplistic measurements, risk analysis becomes a real challenge – see “Risk,” January 6, 2006). But clearly, for an oversimplified example, if buyout funds X and Y buy similar kinds of companies and end up with similar IRRs and TCRs, but Fund X uses far less leverage than Fund Y, I would tend to say that Fund X did a superior job. Their IRRs and TCRs alone tell us nothing about their respective riskiness.

Since it’s risk-adjusted return that counts, can we tell whether her return was more than commensurate with the risks borne or less than commensurate? I’m confident that the answers lie in skilled, subjective judgments, not highly precise but largely irrelevant ratios of return to volatility.

The first is that people care more about return and are more titillated by it. But the second is that it can be far from obvious who did the best job of risk management. Different investors can define investment risk differently, but if it isn’t the same as inter-month or inter-year volatility – and I’m convinced it’s not – then it can’t be easily observed and quantified. This is especially true in good years, when risk remains invisible. One portfolio manager makes 10% and another makes 15%. Who did the better job? When I attended the University of Chicago in 1967, I was taught that in order to decide how well a portfolio had performed, you have to assess how much return was achieved UandU how much risk was borne. That still makes sense to me. How much risk did a manager take? Which manager’s risk-adjusted return is higher? It can be hard to judge these things, but investors shouldn’t wait for a down year to attempt an answer. Modern portfolio theory and the efficient market hypothesis define risk as volatility and tell us that markets price assets so they’ll offer returns that are proportional to their risk, no more and no less. For this reason, they say, superior risk-adjusted returns cannot be achieved. The beauty of inefficient markets – to the extent they exist – lies in the belief that this rule need not hold: that you can get more return than is justified by the risk.

Portable alpha proposes the following: Suppose, for example, you want to invest $100 million in mainstream stocks, and you also want alpha, leading to superior risk-adjusted returns. The problem is that, traditionally, investors wanting to invest in a given asset class have been restricted in their search for alpha to managers operating in that class. But if you acknowledge that alpha is hard to achieve in mainstream stocks given the high degree of market efficiency, you can use portable alpha to “transport alpha” earned in any other asset class to the portion of your portfolio allocated to mainstream stocks. So you give up on finding your alpha in the mainstream stock market and pursue it by assembling a “value-added” portfolio of funds run by highly skilled managers in a wide variety of markets – probably in alternative investing fields such as hedge funds, private equity, commodities, etc., and probably not in mainstream stocks. Then you assess how much market exposure is embedded in the value-added funds and, using derivatives such as futures, swaps and options, you add market exposure until the beta of the total portfolio equals the beta of $100 million of stocks. In this example, the market exposure implicit in the derivatives plus the funds gives you the return on a $100 million passive portfolio of stocks, and the skillful management of the funds gives you their managers’ value added.

© 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.

© Oaktree Capital Management, L.P. All Rights Reserved Value-added funds that generate alpha clearly are an essential ingredient if portable alpha is going to work. Many managers claim the ability to generate alpha based on their skill, experience and access to alpha-generating strategies. But only the best will prove able to accomplish the difficult task of obtaining true alpha, after returns have been adjusted to recognize embedded beta bets. Thus real alpha may not always be responsible for portable alpha’s contribution. In my opinion, a more common reason for a portable alpha portfolio to deliver higher returns over time may be that it entails leverage. Because the value-added funds may not be as “market neutral” or “absolute return” as is thought – and because portable alpha managers may fail to properly adjust for embedded betas – the market exposure delivered by the total portfolio can end up being more than would be entailed in its benchmark (e.g., a traditional long-only stock portfolio). In that case, the portable alpha portfolio will represent a leveraged position. (That is, the sum of the beta on the derivatives plus the beta on the funds may exceed the beta of a traditional stock portfolio.) If that’s true, the portable alpha portfolio should provide higher returns in up markets than the traditional portfolio.

This will be so as long as traditional managers’ alphas aren’t sufficient to offset both the leverage and the value-added fund managers’ alphas (which everyone assumes is out of the question given today’s belief in alternative funds and disrespect for traditional investing). But the portable alpha portfolio may lose more in down markets unless the value-added fund managers’ alpha exceeds the traditional managers’ alpha by enough to offset the increased losses that can stem from a portable alpha portfolio’s leveraged market exposure. Now then, if pension funds or endowments aren’t permitted to borrow to achieve leverage and want to increase market exposure this way, I say “have at it.” But they should call it what it is, rather than insist that they’re combining 2 plus 2 and getting 5. And remember that even after a portable alpha program has been in place for a period of years and produced results ahead of its benchmarks, it may not be possible to accurately assess whether the advantage came from the skill of the value-added managers, the effectiveness of the portable alpha approach, or leveraged market exposure. Because risk often is truly invisible, you can’t always tell how much market risk you bore, and thus whether the key was really alpha or beta. Portable alpha has the potential to improve results – in good markets and generally over time (since markets usually go up).

© Oaktree Capital Management, L.P. All Rights Reserved invests in hedge funds]. “They were more leveraged than they realized.” (The Wall Street Journal, September 20) TAfter the fall, the Journal quotes Mr. Maounis as saying Amaranth’s traders “were surprised not only by adverse market moves that triggered the losses but also by the lack of ability to exit the losing positions.” That’s it, right there: the word “surprise.” It’s one thing to make an investment you know is risky and have it come out wrong. It’s something entirely different to make an investment that entails risk of which you’re unaware. TMr. Maounis and Amaranth’s risk managers shouldn’t have been surprised. They should have been alerted by the volatility of the fund’s energy results. According to Till, its LPs should have been as well. “Investors would not have needed position-level transparency to realize that Amaranth’s energy trading was quite risky.” But the evidence of that potential risk came primarily in the form of outsized gains, and these are rarely recognized as the red flag they are. TAmaranth’s investors relied heavily on its vaunted risk management capability and on the assurance that risk was under control. But the fund failed to survive its seventh year. Quantitative risk managers can only opine on whether a disaster is likely or not. Even if they’re right about that, it’s up to you to decide whether you’re willing to bear the risk of an improbable disaster. They do happen!

© Oaktree Capital Management, L.P. All Rights Reserved None of these activities is imprudent in and of itself. But they all involve substantial risk and should be undertaken only by people possessing the essential edge: sufficient expertise in the relevant field to be able to know when the opportunities are truly attractive. U Why This Appetite for Risk? In my memo on hedge funds of two years ago, I cited an insightful piece from Byron Wien of Morgan Stanley called “In Praise of Hedge Fund Volatility.” In it, he observed that many hedge funds have become asset gatherers for whom the retention of assets and the receipt of management fees have become more important than the achievement of high returns and the earning of incentive fees. Thus low volatility has supplanted high return in the pantheon of virtues. In my view, this trend has reached beyond hedge funds to additional corners of the alternative investing world. The concept of management fees sufficient to “pay the light bill” seems obsolete. For example, even at just 1¼% per annum, a $15 billion buyout fund can generate more than $1 billion of management fees over its lifetime. Add to that the “deal fees” and “monitoring fees” commonly charged and it’s easy to picture managers becoming wealthy irrespective of performance.

TU Classic Investment Mistakes THemlines go up and down. Ties go from wide to narrow and back again. There are only so many ways in which things can vary. Likewise, there are only a few mistakes one can make in investing, and people repeat them over and over. It seems Amaranth made several.  TBorrowing short to buy long (and illiquid). This cardinal sin is at the root of most great investment debacles. A fund’s capital should be as long-lived as its commitments. And no fund should promise more liquidity than is provided by its underlying assets. You can successfully invest in volatile assets if you’re sure of being able to ride out a storm. But if you lack that certainty and face the possibility of withdrawals or margin calls, a little volatility can mean the end. In the case of Amaranth, just as had been true of Long-Term Capital Management and the big junk bond holders that were forced to sell out at the 1990 lows, many of the losses would have turned back into profits if they had just been able to hold on through the crisis. That’s why I always caution, “Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average.” It’s not enough to be able to get through on average; you have to be able to survive life’s low points.  TConfusing paper profits with real gains.

And some will be egged on by clients emphasizing their desire to invest large amounts of money with low volatility and downplaying the need for high returns. Managers who do not want to be so affected (and their clients) must strongly resist this trend. Recognizing it is the first step in doing so.

© Oaktree Capital Management, L.P. All Rights Reserved There’s no one “right” answer regarding the hedge ratio. Setting it entails estimation regarding the future volatility of the common stock among other things. Thorp’s methodology helped him to profitably determine hedge ratios. UThe Backdrop As the interest in hedge funds rose over the last ten years, “convert arb” became the model of an absolute return strategy. It seemed capable of grinding out returns in the teens almost every year. This occurred without significant exposure to market fluctuations, because every position was hedged. The table below shows the 1995-2003 returns for the market-weighted index of convertible arbitrage funds in the CSFB/Tremont Arbitrage Index. Year Annual Return 3-Year Return 5-Year Return 9-Year Return 1995 16.6% 1996 17.9 1997 14.5 16.3% 1998 -4.4 8.9 1999 16.0 8.3 11.8% 2000 25.6 11.7 13.5 2001 14.6 18.6 12.8 2002 4.0 14.4 10.7 2003 12.9 10.4 14.4 12.8% 12.8% per year for nine years. Only one down year in nine, and that a loss of just 4.4%. No three-year period with an annualized return worse than 8.3%. No five-year period not in double digits. What a record!! 1BURule Number One: Money Matters So what happens? Money floods in. Whereas a few smart people had been able to churn out consistently good results with small amounts of capital, now a crowd was fighting over the convert arb ideas, armed with much more money.

© Oaktree Capital Management, L.P. All Rights Reserved magnitude of the hedge fund movement, a memo on the subject has become inevitable. First, what are hedge funds? Briefly put, they’re unregulated private partnerships that commingle the assets of institutions and wealthy individuals in pursuit of superior investment results. They’re evergreen vehicles that offer periodic withdrawal opportunities to their investors, as opposed to closed-end entities such as private equity funds that promise no option to withdraw but begin to liquidate after a certain date and return money as they do. Except for one other factor, they can have very little else in common. Hedge funds operate in a great many ways. There are arbitrage funds in fixed income, mergers, convertibles and “stat arb”; long/short funds in stocks in general, tech stocks and emerging markets; macro funds which place bets on currencies and world markets; and funds which make mostly-long bets in specialized market niches such as distressed debt. There are small hedge funds and enormous hedge funds. Some hedge funds hedge – go short or otherwise take offsetting positions designed to reduce risk – and others don’t. Thus some aim for steady returns with little volatility and market exposure, and some make massive, unhedged bets in pursuit of massive returns. Some hedge funds can fairly be described as pursuing “absolute return,” and in the rest the returns are anything but absolute.

I think investors should pay above average fees only for asymmetric value added – that is, for a potential increment to returns that isn’t accompanied by a corresponding potential decrement. And I think only genuine skill adds asymmetrically to investment results, not leverage and not the mere ability to use a wide range of investment tactics. The key in hedge fund investing is finding managers who have that skill. It isn’t ubiquitous. UA Few Words on Performance Frankly, I wonder whether the decision to invest in hedge funds today is fully supported by their performance in 2000-04, their period of great popularity. I’ve watched institutions decide to join hedge funds. I think most of them invested for “absolute returns” – which I believe were supposed to be in the high single digits after fees – accompanied by low volatility and limited correlation with the mainstream markets. Now most institutions seem to be satisfied with their hedge fund performance and are signing up for more. But I wonder whether they should be. For the purposes of the analysis below I’ll use the CSFB/Tremont Hedge Fund Index.  With the S&P 500 down 9%, 12% and 22% in the 2000-02 bear market, investors in the CSFB/Tremont Index’s average fund were delighted to make money, with the Index returning 4.9%, 4.4% and 3.0% in those years, respectively.

© Oaktree Capital Management, L.P. All Rights Reserved necessarily-representative period. In addition, it’s weakened by post-selection bias (low-return funds are unlikely to volunteer their performance) and survivorship bias (the estimated 25% of funds that go out of business each year are even less apt to do so). Importantly, holdings of illiquid or infrequently marked securities can cause betas and risk to be understated and thus Sharpe ratios to be overstated (Pensions & Investments, August 19, 2002).  It is obvious that some of the tactics employed by hedge funds entail considerable volatility and illiquidity. And yet, hedge funds give their investors the periodic right to withdraw. Thus, it’s possible for a hedge fund to offer more liquidity than does its underlying investment portfolio. This can be a formula for disaster. Given that a lot of the capital now in hedge funds is “hot money” prone to exit given a period of underperformance, it’s not hard to envision (and in fact the community has seen) rapid-fire withdrawals that lead to downward spirals and penalize the last investors out the door, who can find themselves owning disproportionate amounts of hard-to-value and hard-to-sell securities.  In most hedge funds, it’s hoped that the managers’ actions will neutralize the effect of market fluctuations. In other words, you’re betting on the managers’ skill, not the market direction.

© Oaktree Capital Management, L.P. All Rights Reserved falling price, instead of deterring people from selling, triggers a growing flood of selling, and instead of attracting buyers, a falling price drives potential buyers from the market (or, even worse, turns potential buyers into sellers.)” This phenomenon can occur for reasons ranging from transactional (they receive margin calls) to emotional (they just get scared). The liquidity demanders increase in number, and they become more highly motivated.  In times of crisis, liquidity suppliers become scarce. Maybe they spent their capital in the first 10% decline and are out of powder. Maybe the market’s increased volatility and decreased liquidity have reduced the price they’re willing to pay. And maybe they’re scared, too. “Information did not cause the dramatic price volatility. It was caused by the crisis- induced demand for liquidity at a time that liquidity suppliers were shrinking from the market.” 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 amounts to 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 a year of irrational, liquidity-driven crisis as was 1987.

© Oaktree Capital Management, L.P. All Rights Reserved should suffice. In good times the greatest rewards are likely to go for risk bearing rather than for caution. Thus, to beat the averages in good times, we’d probably need to accept above-average risk . . . risk that could turn around and bite us in a minute. There is a time when it’s essential that we beat the market, and that’s in bad times. Oaktree and its clients don’t want to succumb to market forces in bad times and participate fully in the losses. And because we don’t know when the bad years will come, we insist on investing defensively all of the time. Our goal is to generate performance that is average in good times (although we’ll accept more) and far above average in bad times. If in the long run we can accomplish this simple feat (which time has shown isn’t simple at all), we’ll end up with (a) above-market performance on average, (b) below-market volatility, (c) highly superior performance in the tough times, helping to combat people’s natural tendency to “throw in the towel” at the bottom, and thus (d) happy clients. We’ll settle for that combination. The most important thing is facing up to the limits on your knowledge of the macro- future. Investing means dealing with the future – anticipating future developments and buying assets that will do well if those developments occur. Thus it would be nice to be able to see into the future of economies and markets, and most investors act as if they can.

© Oaktree Capital Management, L.P. All Rights Reserved being average in up markets. Oaktree portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential. Clearly, if we can keep up in good times and outperform in bad times, we’ll have above average results over full cycles with below average volatility, and our clients will enjoy outperformance when others are suffering. We think that’s a winning long-term combination. Our game plan is built around defense. But that’s not enough. We still need players with superior skills. UFinding Your Role Model An article in the Wall Street Journal of August 8, entitled “Greatness in Our Midst,” supplied the immediate impetus for this memo. It attempted to determine “who’s the greatest living baseball player?” I’m no expert on baseball, but I liked the Journal’s analytical approach and loved its conclusions. Of the five players discussed, Barry Bonds came in fifth. “If you’re looking for a peak- value player – a guy to play one season as well as anyone ever has – this is your guy. His past two campaigns have been other-worldly . . .” Bonds has a ton of ability, but he has yet to prove that he’s “the greatest.” Lots of fence-swinging investors have had otherworldly years, but few have completed outstanding careers. Stan Musial placed fourth: outstanding at the plate, but below average on defense according to the Journal. It’s tough to be the best without strong defense. The #3 pick was Willie Mays.

© 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.

© Oaktree Capital Management, L.P. All Rights Reserved But neither does this manager (he just moves half as much as the benchmark): Period Benchmark Return Portfolio Return 1 10 5 2 6 3 3 0 0 4 -10 -5 5 20 10 Or this one (he moves twice as much): Period Benchmark Return Portfolio Return 1 10 20 2 6 12 3 0 0 4 -10 -20 5 20 40 This one has a little: Period Benchmark Return Portfolio Return 1 10 11 2 6 8 3 0 -1 4 -10 -9 5 20 21 While this one has a lot: Period Benchmark Return Portfolio Return 1 10 12 2 6 10 3 0 3 4 -10 2 5 20 30 This one has a ton, if you can live with the volatility. Period Benchmark Return Portfolio Return 1 10 25 2 6 20 3 0 -5 4 -10 -20 5 20 25

Remember what Lord Keynes said about the ability of markets to remain irrational for long periods of time. And remember that it's possible for you to be forced to sell at the bottom – by emotions, competitive pressure or the need for liquidity – turning temporary volatility (the theoretical definition of risk) into very real permanent loss. In order to get more out of the ups of stocks and try to lessen the pain of the downs, most people turn to active management via market timing, group rotation, industry emphasis and stock selection. But it's just not that easy. The American Way – earnestly applying elbow grease – doesn't often payoff. For a model, don't think about the diligent paperboy on his route; think about trying to profit from flipping a coin. I say that because I believe most markets are relatively "efficient," and that certainly includes the mainstream stock market. Where large numbers of investors are aware of an asset's existence, have roughly equal access to information and are diligently working to evaluate it, the market operates to incorporate their collective interpretation of the information into a market price. While that price is often wrong, very few investors are capable of consistently knowing when it is, and by how much, and in which direction. The evidence is clear: most investors underperform the market.

 Randomness alone can produce just about any outcome in the short run. The effect of random events is analogous to the contribution from beta discussed on page six. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he's the rare timer who's capable of getting it right repeatedly).  For these reasons, investors often receive credit they don't deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these "geniuses" are right more than once or twice in a row.  Thus it's essential to have a large number of observations – lots of years of data – before judging a given manager's ability.follows:

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: What's It All About, Alpha? With apologies to Burt Bacharach and Dionne Warwick, whose 1966 rendition for the movie "Alfie" was much more artistic, I couldn't resist adapting their title for a memo on investment theory. What's it all about, indeed? Everyone talks about alpha . . . and beta, risk and return, and efficiency and inefficiency. But I believe few people use them to mean the same thing, or correctly. Thus the thinking I did about alpha while writing "Safety First" in April has convinced me to set out my views on all of these subjects. In this connection, my 1967-69 attendance at the University of Chicago Graduate School of Business was pivotal. I had previously been at a non-theoretical Wharton, where I learned investment practice à la Graham and Dodd but not one word on what I'm about to discuss. At Chicago I found a new theory of investments that would revolutionize the field. My exposure to it was eye-opening and kept me from becoming an unquestioning member of what I call the "I know" school of investing (where people think a little effort is all it takes to know the future direction of any stock or market). The 32 years since Chicago have given me enough time to forget a lot of the theory I learned . . . but also, most importantly, the real-world experience needed to leaven it, leading to my own synthesis of theory and practice.

© Oaktree Capital Management, L.P. All Rights Reserved larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.  UCycles are self-correctingU, and their reversal is not necessarily dependent on exogenous events. The reason they reverse (rather than going on forever) is that trends create the reasons for their own reversal. Thus I like to say success carries within itself the seeds of failure, and failure the seeds of success.  Seen through the lens of human perception, Ucycles are often viewed as less symmetrical than they areU. Negative price fluctuations are called "volatility," while positive price fluctuations are called "profit." Collapsing markets are called "selling panics," while surges receive more benign descriptions (but I think they may best be seen as "buying panics"; see tech stocks in 1999, for example). Commentators talk about "investor capitulation" at the bottom of market cycles, while I also see capitulation at tops, when previously-prudent investors throw in the towel and buy. I have views on how these general observations and others apply to specific kinds of cycles, which I will set forth below. UThe Economic Cycle Few things are the subject of more study than the economy.

They will be propelled to great heights, usually by the rationalization that "it's different this time; productivity, technology, globalization, lower taxation – something – has permanently elevated the prospective return from stocks." The bear markets will come as a shock to the unsuspecting, demonstrating that, most of the time, the world doesn't change that much. For example, when you look at Siegel's 200-year straight-line stock market graph, no hiccup is visible in 1973-74. Try telling that to the equity investors who lost half their money. The bottom line is that risk of fluctuation is always present. Thus stocks are risky unless your time frame truly allows you to live through the downs while awaiting the ups. Lord Keynes said "markets can remain irrational longer than you can remain solvent," and being forced to sell at the bottom – by your emotions, your client or your need for money – can turn temporary volatility (the theoretical definition of risk) into very real permanent loss. Your time frame does a lot to determine what fluctuations you can survive. UActive managementU – In order to get more out of the ups and try to lessen the pain of the downs, most people turn to active management via market timing, group rotation, industry emphasis and stock selection. But it's just not that easy. The American Way – earnestly applying elbow grease – doesn't often payoff.

© Oaktree Capital Management, L.P. All Rights Reserved Dispersion of Active Management Returns Identifies Areas of Opportunity Asset Returns by Quartile, Ten Years Ending December 31, 1997 Asset Class First Quartile Median Third Quartile Range U.S. fixed income 9.7% 9.2% 8.5% 1.2% U.S. equity 19.5 18.3 17.0 2.5 Int'l equity 12.6 11.0 9.7 2.9 Real estate 5.9 3.9 1.2 4.7 Leveraged buyouts 23.1 16.9 10.1 13.0 Venture capital 25.1 12.4 3.9 21.2 As the table shows, the range between the 25P th P percentile and the 75 P th P percentile of investors in what I think are relatively inefficient markets (venture capital and leveraged buyouts) is UmuchU broader than it is in more efficient markets (mainstream stocks and bonds). This supports the belief that in inefficient markets, either (a) prices diverge more from intrinsic values, (b) there's more variation among investors in terms of skill, (c) that variation has more impact, or (d) all of the above. Any way you slice it, hiring a superior manager is more crucial in the inefficient markets. UReturnU – The terms alpha and beta are derived from the basic form of an algebraic equation, which is: y = a + bx Thus in investments we say a portfolio's result can be predicted by the equation: return = alpha + (beta x the market's return) Beta is a coefficient equal to the proportion of the market's return that the portfolio can be expected to capture.

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

Even the "I know" investors, who buy on the assumption they're right, insist on liquidity – because they know there's a good chance they'll be wrong and need to beat a retreat. But the more you can see the future, the less likely you'll be wrong, and the less risk there is that exiting could be difficult. In reality, then, not just investment theory, but also a great deal of everyday practice, is built around the acknowledgement that alpha – skill and foresight – is a scarce commodity. URiskU – It's essential that investors consider risk. In the time since I entered the investment field, return has increasingly come to be evaluated in risk-adjusted terms. Everyone knows that if two portfolios return 8% a year for five years, the two managers didn't necessarily do an equally good job of investing. If one did it with T-bills and the other with emerging market stocks, the first manager almost certainly did a better job – since he earned the same return with far less risk. That's real added value, just like earning more return with the same or less risk. To know how good a job a manager did, then, you have to have a good idea how much risk he took. Yet I think risk may be the area where both theory and many aspects of practice are furthest from right. The first thing you learn in investment theory, and one of the most widely agreed-on assumptions in practice, is that "volatility equals risk."

© Oaktree Capital Management, L.P. All Rights Reserved I believe the academicians of the 1950s and '60s were influenced to accept volatility as the measure of investment risk by its two outstanding virtues: it is (a) absolute and (b) quantifiable. They can tell you precisely what the standard deviation of a stock or a portfolio's return was in the past, and thus it only takes a little extrapolation to project what it's going to be in the future. I will suggest some other ways to think about risk, but (a) they will vary from person to person and from situation to situation, and/or (b) they will not be easily quantified. Thus they won't permit you to say that one asset or portfolio would be riskier than another (other than possibly in a given application). You won't even be able to say how risky an asset or portfolio was in the past. What is risk? First of all, I don't think risk is synonymous with volatility. And second, the indicia of risk vary by asset class. At Oaktree, when we think about adding an asset to a portfolio, we ask whether the risk entailed is tolerable (i.e., within our charter from our clients) and offset by the likely return. And by risk we mean the chance of losing our clients' money. In high yield bonds we concentrate on the risk of default and how much principal would likely be unrecoverable. In distressed debt we wonder whether the company's assets will turn out to be worth less than we think or the reorganization will go against us.

In convertibles and emerging market equities we worry about the chance a stock will decline and the likelihood that our protective efforts will fail to insulate us. We do not think about volatility. With our capital in either locked-up funds or long-term relationships, we worry only about whether the ultimate result, perhaps years down the road, will be positive or negative, and by how much. We think this is what our clients pay us to do. But we make no claim that this approach to risk is subject to quantification or numerical manipulation. Bruce Karsh probably couldn't have quantified the riskiness of Conseco bonds at the time we bought them last June. Richard Masson and Matt Barrett probably wouldn't have agreed with him, or with each other, on the probability of loss. Any figure they settled on probably wouldn't have been in a form that could be equated with risk. And even today, a year later and after having sold the bonds, we still can't quantify the risk we took. It's a concept, a notion, a worry . . . but not a number. This might be the right way to think about risk – it's certainly how we do it – but it wouldn't work at all for a "quant." He'd have no way to state our portfolio's risk, or its risk-adjusted return, or tell whether our performance was superior or inferior. Will an investment lose money? Will a pension fund fail to earn its actuarial assumption? Will an endowment be unable to cover its spending rate? Will a retiree have less than he needs to live on?

© Oaktree Capital Management, L.P. All Rights Reserved Their model called for higher equity allocations, predicting that they would lead to higher overall returns on the portfolio UandU lower risk. Why? Because equities were projected to return 14% and risk was defined as the probability of failing to average 8% over a five- year period. First, I said, I would never have any part in a process that equated higher equity allocations with lower risk. I suggested that risk be defined as overall portfolio volatility, and that took care of that. But second, I questioned the 14% projected return from equities. Equities returned 28% in 1995-99, I said; did someone think halving that made for a conservative projection? No, I was told, the support mostly came-from the 13% long-run return on equities:--(I always thought it was 10% or so, but it seems the last five years have changed all that.) I could only think of one way to respond: I offered to put up my money against that of the consultant's researchers and “take the under.” I doubt strongly that equities will return 14% or anything like it in the next decade. Corporate earnings have traditionally grown at single-digit rates, and I don't feel that's about to change substantially. With p/e ratios unlikely to rise further and dividends immaterial, single-digit earnings growth should translate into single-digit average equity performance at best for the foreseeable future.

” What they offer is liquidity; providing liquidity entails risk to them (which increases as the market's volatility increases and as its liquidity decreases); and the profit they expect to make is their price for accepting this risk. “To liquidity suppliers, price matters much more than time.”  Usually when the price of something falls, fewer people want to sell it and more want to buy it. But in a crisis, “market prices become countereconomic,” and the reverse becomes true. “A falling price, instead of deterring people from selling, triggers a growing flood of selling, and instead of attracting buyers, a falling price drives potential buyers from the market (or, even worse, turns potential buyers into sellers.)” This phenomenon can occur for reasons ranging from transactional (they receive margin calls) to emotional (they get scared). The number of liquidity demanders increases, and they become more highly motivated. “Liquidity demanders use price to attract liquidity suppliers, which sometimes works and sometimes does not. In a high-risk or crisis market, the drop in prices actually reduces supply [of liquidity] and increases demand.”  In times of crisis, liquidity suppliers become scarce. Maybe they spent their capital in the first 10% decline and are out of powder. Maybe the market's increased volatility and decreased liquidity have reduced the price they're willing to pay. And maybe they're scared, too. Bookstaber recalls the Crash of 1987.

After the first leg down, liquidity suppliers “had already ‘made their move,’ risking their capital at much lower levels of volatility, and now were stopped out of their positions by management or, worse still, had lost their jobs. Even those who still had their jobs kept their capital on the sidelines. Entering the market in the face of widespread destruction was considered imprudent ... Information did not cause the dramatic price volatility. It was caused by the crisis-induced demand for liquidity at a time that liquidity suppliers were shrinking from the market.”

© Oaktree Capital Management, L.P. All Rights Reserved (If I'm right in saying risk tolerance turned to risk aversion in 1998, you might ask how the tech/media/telecom boom could have continued into 1999 and early 2000. The answer: it's the exception that proves the rule. Even as investors were turning more conservative and capital was being withdrawn from hedge funds and banks' and brokers' proprietary portfolios, the crowd took to TMT investing in a way that ignited the IPO boom and everything that followed. It's often said that at the end of a bull market the vast majority of stocks weaken while one popular sector goes on to a highly extended extreme before collapsing. Certainly that's what happened in 1999, when the tech-dominated NASDAQ rose 86% at the same time that the S&P 500 excluding technology was up only 3% (Wall Street Journal, December 21). In 2000, the last holdouts – the TMT aficionados – finally realized that they had overstated their companies' potential, ignored their dependence on a benign environment, understated the danger implied by the market's manic volatility and paid too much for their stocks. All of the positives of 1999 turned into negatives, with catastrophic results. The declines in the TMT stocks in 2000 provide a tangible reminder that psychology can change much faster than fundamentals. A little fundamental deterioration, when mixed with increased pessimism, can wreak absolute havoc with asset prices. UNow What?

On August 25, 2000, a false press release was picked up on the Internet, taking Emulex stock from $103 to $45 within twenty minutes. After a few-hour trading halt, corrected information took it back above $100. Glassman's term for the markets: “dazzling in their efficiency.” He finds comfort in the fact that both the falsified data and the correction were disseminated so quickly. I feel the rapid and universal distribution of information - often at speeds and in amounts that make it impossible to verify, distill and understand - does nothing to make the markets safer per se. For proof, look at the trend in volatility. It seems inescapable that media hype and other short-term oriented developments have made the markets more treacherous. Looking at today' s mass market and the associated flood of information, my partner Sheldon Stone sees investors as passengers on a boat, running back and forth en masse -to one side in response to new information, and then back to the other. That makes for a rocky crossing. Where does Glassman go wrong? To me, his error is obvious in the following sentence: Markets know so much more about companies, and know it so quickly, that their assessments of worth have an up-to-the-minute efficiency and accuracy.

© Oaktree Capital Management, L.P. All Rights Reserved The bottom line for me: Efficiency and accuracy are two very different things. As I wrote in my May memo, investors rapidly incorporate new information into their estimates of security values, and the market rapidly reflects the consensus view of values,...but that doesn't mean the consensus is right. Information isn't knowledge. The mere fact that investors have data doesn't mean they understand its significance. If investors' knowledge was really growing, stock volatility wouldn't be increasing as dramatically as it is. As the adage says of the fool, “he knows the price of everything and the value of nothing.” November 16, 2000

Not only is it insufficient to enable those possessing it to control the future, but awe of it can cause people to follow without asking the questions they should and without reserving enough for the rainy day that inevitably comes. This is probably the greatest lesson of Long-Term Capital Management. There are others, which I'll review below. 1) As I've written before, "volatility + leverage = dynamite." The main cause of Long-- Term's collapse probably wasn't its security selection, or the declines in its markets, but rather its leverage. On average, its positions may have declined just a few percent. But when your assets exceed 25 times your equity, even a 4% price decline is enough to wipe you out. Nowadays, most people use the word "leverage" interchangeably with "debt." But it's better understood in the sense I first learned: the extent to which a change in the top line is magnified by the time it reaches the bottom line. That's why the British call it "gearing." In Las Vegas they say “the more you bet, the more you win when you win.” They never add "… and the more you lose when you lose.” Leverage is just a way to let you bet more than your capital, and it exposes you to more of the good and more of the bad. Leverage can truly be dynamite. None of Oaktree's portfolios use leverage to invest more than our capital (although our Emerging Markets Fund will be able to do so to a limited extent).

As one "fund of funds" which had invested in the Granite Fund told the Wall Street Journal, "It's unbelievable. This was touted as a low-risk, low- volatility, market-neutral investment. We were clearly misled." Only by really knowing what a manager does can you be sure he is right for you, but this often comes down to whether the manager truly understands his market, describes it accurately and does what he says he will -- things that can't be assessed from a marketing brochure. - Investment strategy really is a two-edged sword, and he who lives by an aggressive strategy usually can die by it. It proved possible for investors to become too comfortable with volatility -- when it was on the upside and called "profit." Volatility is a lot less enjoyable when it turns to the downside, but it's the flip side of the same coin. - The outcome can actually be worse than symmetrical when incentive fees are involved, as Jan Greer of William Simon & Sons points out. That's because while hedge fund managers took 20% of last year's big profits, they won't replace a like percentage of subsequent losses. Usually, due to the peculiarities of the math, if a portfolio is up 50% one year and down 33% the next, it's back to where it started. But if the manager takes a fifth of the 50% gain in year 1, a 33% decline in year 2 will leave it 7% under water.

© Oaktree Capital Management, L.P. All Rights Reserved - As an experienced corporate director told Forbes a few years ago, "I no longer expect people to do what I tell them to do; I've learned they only do what I pay them to do." But while a hedge fund manager may have his reputation and some capital at stake, as to fees he is in a heads-we-win-tails-you-lose position. For a manager who is paid a percentage of the profits on a one-year- at-a-time basis, a single year of investing aggressively enough at the right time can make him rich for life. Thus managers should be entrusted with incentive fee arrangements only if they can truly be counted on to add significant value which is UnotU accompanied by proportionate risk. - Volatility + leverage = dynamite. Only now do we see articles pointing out (after the fact) that if a hedge fund borrows short to buy long Treasury bonds with 6% "down," a 1% rise in the bonds' yield will wipe out 100% of the equity in the position. - When volatile securities have been bought on margin, sale may be forced if the investor can't come up with more capital during a decline. This is a big part of what put the Granite Fund under. If you own securities without borrowing, you may experience a price drop -- which will hopefully prove temporary -- but you can't be put out of the game. - One characteristic of many inefficient markets is some measure of illiquidity.

© Oaktree Capital Management, L.P. All Rights Reserved Inefficient markets must by definition entail illiquidity and occasional volatility, but we feel unleveraged and expert investment in them offers investors with staying power the best route to high returns without commensurately high risk. And we also feel investors who are capable of observing clinically can learn some valuable lessons from the current episode. We look forward to learning along with you. April 11, 1994

but wrong this time, producing performance which was far enough behind to negate the majority of its 1987 achievement and pull its 18-month results well back into the pack. My observation at that time mirrored the fund manager quoted above, but from a negative viewpoint: . . . in order to strive for performance which is far different from the norm and better, you must do things which expose you to the possibility of being far different from the norm and worse. These cases illustrate that bold steps taken in pursuit of great performance can just as easily be wrong as right. Even worse, a combination of far above-average and far below- average years can lead to a long-term record which is characterized by volatility UandU mediocrity. As an alternative, I would like to cite the approach of a major mid-West pension plan whose director I spoke with last month.last

© Oaktree Capital Management, L.P. All Rights Reserved fourteen years, under the direction of this man and his predecessors, has been way ahead of the S&P 500. He shared with me what he considered the key: We have never had a year below the 47th percentile over that period or, until 1990, above the 27th percentile. As a result, we are in the fourth percentile for the fourteen year period as a whole. I feel strongly that attempting to achieve a superior long term record by stringing together a run of top-decile years is unlikely to succeed. Rather, striving to do a little better than average every year -- and through discipline to have highly superior relative results in bad times -- is: - less likely to produce extreme volatility, - less likely to produce huge losses which can't be recouped and, most importantly, - more likely to work (given the fact that all of us are only human). Simply put, what the pension fund's record tells me is that, in equities, if you can avoid losers (and losing years), the winners will take care of themselves. I believe most strongly that this holds true in my group's opportunistic niches as well -- that the best foundation for above-average long term performance is an absence of disasters.