Chasing Risk


I read the Howard Marks memo last weekend and you should, too, if you haven’t already.  The memo got me to revisit some of my investing viewpoints.  It’s easy to listen to the same investment philosophy on repeat.  My fear is that one day I’ll look up and find that everyone’s streaming their investment philosophy on their phones while I’m listening to a walkman.  So I read everything I can.  Howard Marks is one of the very best.  He’s usually a bit cerebral for me, but the latest memo is perfect.  I ran out of highlighter halfway through my first read.

Right off the bat he lays out four conditions that he sees in the market: unusual uncertainties, low prospective returns, high asset prices, and rampant pro-risk behavior.  I don’t agree with him on the first two points, but asset prices do seem high.  I have a man-crush on the idea that there is increasing pro-risk behavior.

Unusual Uncertainties

Are today’s slate of uncertainties truly unusual?  Perhaps it is our perception of uncertainty which has shifted.  The internet and social media has expanded the universe of information available to us.  This is great if you’re trying to figure out how to put the sink back together (in my defense, I did fix the leak and didn’t have to call a plumber), but it’s not so great if you’re looking for a passive data stream.  I may be an advocate of passive investing, but I firmly believe in actively managing your own news feed.  The internet is not a meritocracy.  It rewards the most outrageous viewpoints.  Maybe this is why it seems like we are hearing more about unlikely scenarios from previously-trustworthy news sources.  I don’t think it’s a case of increased uncertainties so much as we are being exposed to more what-ifs presented without distinction of their likelihood.

Marks cites political dysfunction as an increasing uncertainty and I have to agree there.  However, central banks and interest rates aren’t nearly as uncertain as he makes them out to be.  Central banks are doing everything they can to telegraph their every move, reducing their impact.  If anything, there is more certainty around central banks now than in the past.

Prospective Returns

The idea that we should expect diminished future returns is not a new one.  The latest round of this outlook began with PIMCO’s “New Normal” in 2009.  Returns have been anything but diminished over that time, despite expert predictions.  I don’t understand the obsession with trying to predict returns.  They can be high.  They can be negative.  They can’t be predicted.  It’s more important to accept that there WILL be negative returns rather than trying to avoid them through timing.  Otherwise, we end up reacting to the market instead of using the market to accomplish our goals.

High Asset Prices

Domestic equities do not look cheap.  Developed international and emerging markets are trading at reasonable valuations, but they could remain that way for years.  It doesn’t necessarily mean they’re on the verge of breaking out.  Bond yields are low everywhere, too.  The catch is that assets can remain expensive or become even more expensive for long stretches of time.  Since the financial crisis we’ve seen this with interest rates.  We all know that they’re going up, but the winning strategies have been counter-intuitive.  Shifting to short duration has been anything but defensive.

Pro-Risk Behavior

This is something I’ve been seeing for at least a couple of years now, but I couldn’t put my finger on just what it was.  In my meetings with money managers, almost all of them have been highlighting a new strategy that seems to add more risk than return.  This has been really interesting to watch in the bond space as they have evolved from go-anywhere/opportunistic/strategic income to now everyone is jumping into mortgages.  The equity strategies are generally coming from a smart beta angle.  These were mainly low-vol when that was working.  I also get a ton of pitches for illiquid investments – private equity, hedge funds, and private real estate, mostly.  I also got pitched a horror movie.  Yes, seriously.

The idea of increased pro-risk behavior is the most important theme in the entire memo.  

Josh Brown has warned about the newest fad among wirehouses: securities based lending.  Brokers are urging their clients to take out loans against their portfolios.  It reminds me of the people who took out home equity loans as play money during the run-up to the financial crisis.  Morgan Stanley has had a run of positive earnings announcements in no small part to its portfolio lending program ($74 billion in loans to wealth clients last quarter).  Adding leverage at this point seems more likely to reduce one’s tolerance to a downturn rather than act as a return enhancer.

In investing, there’s no such thing as risk-less return, but there is return-less risk.  The more investors seek out (or are sold, more likely) novel investment ideas, the weaker the deal structures are likely to be for them.  Investors who just want a piece of the action of a hot private equity fund, IPO, or *gulp* ICO can easily overlook the fact that risk comes not only from the investment, but also from the structure surrounding that investment – management fees, liquidity, etc.

While it’s 22 pages, the Howard Marks memo is a worthwhile read.  I certainly found it helpful.