Six investment options that may tempt you in low-return markets
• It would be folly to expect to earn traditional returns from investing in the traditional way
In September’s memo, Oaktree Capital’s Howard Marks tackles the fact that his prior memo, There They Go Again … Again, of July 26, “generated the most response” in the 28 years he’s been writing memos and a lot of questions in one form or another of, “So what should I do?”.
“In the low-return world I described in the memo,” says Marks, “the options are limited: 1 Invest as you always have and expect your historic returns. 2 Invest as you always have and settle for today’s low returns. 3 Reduce risk to prepare for a correction and accept still lower returns. 4 Go to cash at a nearzero return and wait for a better environment. 5 Increase risk in pursuit of higher returns. 6 Put more into special niches and special investment managers.
“It would be sheer folly to expect to earn traditional returns today from investing like you’ve done traditionally (#1). With the risk-free rate of interest near zero and the returns on all other investments scaled based on that … few if any asset classes will return in the next few years what they’ve delivered historically. Thus, one of the sensible courses of action is to invest as you did in the past but accept that returns will be lower (#2).
“Sensible, but not highly satisfactory … No one wants to make less than they used to. If you believe [risk is high] today, you might want to opt for #3. If you think a correction is coming, reducing your risk makes sense. But what if it takes years to be proved right? Going to cash (#4) is the extreme example of risk reduction. Are you willing to accept a return of zero as the price for being assured of avoiding a possible correction? Most investors can’t or won’t voluntarily sign on for zero returns. All the above leads to #5: increasing risk as the way to earn high returns in a low-return world.
“But high risk does not assure higher returns. It means accepting greater uncertainty with the goal of higher returns and the possibility of substantially lower (or negative) returns .... it should be done with great care, if at all.
“And that leaves #6. Special niches and special people … can deliver higher returns without proportionally more risk…. But it’s not easy [and] has to be based on the belief that … there are inefficient markets and … you … have the exceptional skill needed to exploit them.”
Marks says none of these possibilities is attractive or a sure thing, “but there are no others”. So, what would he do?
“For me the answer lies in a combination of numbers 2, 3 and 6,” he says. “Expecting normal returns from normal activities (#1) is out in my book, as are settling for zero in cash (#4) and ramping up risk in the hope of draws from the favourable part of the probability distribution (#5). 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 emphasise ‘alpha markets’ where hard work and skill might add to returns (#6), since there are no ‘beta markets’ that offer generous returns today.”
Ben Carlson agrees with Marks that 2, 3 and 6 are the best options and looks at the pros and cons for each.
“Given current valuation and interest rate levels,” says Carlson, “it makes sense that market returns should be lower going forward. Doing nothing is a decision. The simplest option for most investors is to stick with their long-term investment plans and adjust their expectations. As long as you can keep your costs and expectations in check, there’s no reason sticking with a well-thought-out strategy shouldn’t continue to work.
“[Unfortunately] if markets are unable to do the heavy lifting, investors are going to have to pick up the slack to earn their fair share of market returns.
“Lower market returns likely mean people should save more, make more, work longer, spend less or adjust their lifestyle in retirement.
“Reducing risk enables you to take advantage of future opportunities. The hope is that you can put more money to work at lower valuations or higher yields if and when things eventually go wrong. Cash is an option.
“On the downside, you could be waiting a long time to put your money back to work, so extreme patience is required. Timing the market is also a gateway investment to a cash addiction. There are always good reasons to wait for another buying opportunity.
“When stocks go up, you tell yourself you’ll wait for a correction, and when a correction comes, you tell yourself you’ll wait until they drop just a little further. There are no all-clears when things are going down, so you must incorporate rules to guide your actions.
“Going to cash also means you have to be right twice — once when you get out and again when you get back in.
“Niche investments and specialised investment managers can offer uncorrelated return streams, provide downside protection or take an opportunistic approach to the markets.
“Risk-adjusted outperformance through a unique manager or strategy can add value as a return enhancer or portfolio diversifier. [However] it’s tough to find consistent sources of alpha in the markets because of increased competition, high costs and lack of access to the best money managers. Marks is one of the greatest investors of all time, but it’s nearly impossible for most of the investing public to invest in his funds as they are reserved mostly for large institutional investors.”
If diversification is a form of regret minimisation, diversification by strategy is an intelligent way to minimise the probability of making the wrong choice.
And, even if Marks’s market uncertainties turn out not to be as unusual “in terms of number, scale and insolubility” as he supposes, what’s the worst that can happen should you refuse to fall into line in carefree markets like today’s?
“It’s likely, that, for a while, you’ll … lag in terms of return and … look like an old fogey,” says Marks. “But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs.”
THE HOPE IS YOU CAN PUT MORE MONEY TO WORK AT LOWER VALUATIONS OR HIGHER YIELDS IF … THINGS … GO WRONG