Howard Marks, co-founder of Oaktree Capital Management, is known for his often prescient, often contrarian market commentaries—and for making his investors a lot of money. In his new book, Mastering the Market Cycle, he focuses on the importance of figuring out where we are in the cycle to determine investment strategy.
He’s cautious, given all the signs of excess in financial markets. In an interview with WealthManagement.com, he added his voice to the chorus of those who point out that financial advisors risk obliteration by automated competitors if they don’t find a way to add value beyond investment performance, and given the markets today that means helping clients manage their risk.
Wealth Management: Does the continuing automation of the investment business spell doom for retail investment advisors?
Howard Marks: In all parts of the investment industry—as in the rest of the business world—the key question will be, “Can humans do something that machines can’t?” If so, I believe humans will stay in demand and be able to charge appropriate fees. If not, machines will take over.
Much equity management has transitioned to index/passive funds, not because passive performs so well, but because active managers have produced inferior results and charged high fees. Better results and/or lower fees will make advisors viable and successful. Anything else assumes the clients are naive.
I think advisors can do a better job than machines [on helping their clients manage risk]. A skillful advisor who reflects the client’s preferences and knows how to implement them should always be a valuable resource.
WM: Given that we seem to be late in the investment/economic cycle, how should financial advisors guide their clients now?
HM: There are times for aggressiveness and times for caution, and I believe the choice between the two is the most important decision for the intermediate term of two to five years. Aggressiveness is in order when news has been negative, recent performance has been poor, investors are depressed, and thus little optimism is embodied in security prices. When the reverse is true, it’s time for caution.
Today, I observe the advanced age of the economic recovery and bull market, the fact that low interest rates have pushed people into risk assets, and the risk tolerance many people are exhibiting as a result. Consequently, I think this is time for somewhat more caution than aggressiveness.
WM: Are there investment areas that you find attractive or unattractive in this environment?
HM: Most of my observations are market-wide because, for the reasons listed above, I think most assets are priced on the high side of fair or the beginning of rich. My main preference is for a cautious approach in all asset classes.
Long bonds should be avoided because of the likely rise in interest rates. Stocks aren’t priced too badly, with the exception of the top tech and social media names, where considerable optimism is incorporated in prices. Emerging market equities have taken quite a hit and might have appeal for investors with a strong appetite for risk.
WM: How should financial advisors help clients adjust their asset allocations in different market environments?
HM: First, advisors should help every client establish an explicit normal risk posture. Second, based on the thinking that I mentioned earlier, they should decide whether the risk in their portfolio today should be above, below or at the normal level.
After doing that, risk can be adjusted. There are many ways to do so, by moving both between asset classes and within asset classes. Raising or lowering cash is binary—either right or wrong, with no gray area—and it’s difficult to do right. Fortunately, there are many ways to adjust risk without manipulating cash.
WM: What economic/financial/market trends worry you the most now?
HM: Rising interest rates will make it harder for companies to service their debts, increase the federal deficit, retard economic growth, and increase the competition that cash and fixed income instruments provide relative to stocks.
Rates should be expected to continue to rise. The 2017 tax bill will increase economic growth and the likelihood of inflation. It also will increase the annual deficit and national debt. Thus, in order to keep the economy from overheating and inflation from rising, the Fed may have to increase rates more than it might otherwise. The result could be slower economic growth or recession.
WM: Do you worry at all that we could fall back into financial crisis like in the late 1930s?
HM: Anything’s possible, but the Great Depression of the 1930s was a very extreme outcome and not one that should be expected to repeat often. In the last 20 years we’ve seen two bubbles and resulting crashes: tech/internet in 1999 and 2000 and subprime mortgages in 2007 and 2008.
But not every cyclical episode is a bubble/crash. Rather, there can be more moderate bull markets followed by bear markets. Today we don’t have the excesses—especially in terms of leverage in investment products and the financial sector—that produced the global financial crisis in 2007 and 2008. Thus, I don’t feel a replay of the 1930s or 2007 and 2008 is in the cards at this time.
WM: Has investing changed in fundamental ways over the past 30 years?
HM: The changes have been massive. For the better. There’s a greater variety of investment options available today. More importantly, people no longer think good investing consists of buying top-quality assets. The introduction of high-yield bonds 40 years ago led to a mentality wherein risky investments are acceptable as well, as long as the risk is understood and compensated by the potential return. Further, [Nobel Laureate economist] Harry Markowitz introduced the notion, now widely accepted, that by adding risky but uncorrelated assets to a portfolio of safe assets, you can reduce the portfolio’s riskiness. These changes revolutionized the investment world. Finally, there is clearly a movement afoot to pay high management fees only to managers who add value.
WM: What are the negative changes?
HM: The introduction of derivatives, levered structures and financial engineering has increased the complexity of investing: the difficulty of understanding and gauging risk and the potential for financial system-wide risk.
Another change for the worse is the growing shortsightedness of most investors. Who will ignore quarterly performance to wait to see what happens in the long run? But, isn’t long-run performance the only thing that counts?
Then there’s the increasing tyranny of benchmarks. Investment managers are generally evaluated on the basis of their performance versus the benchmarks, but that comparison considers only return, not risk. In times in which the highest returns go to the person who takes the most risk, like the last five years generally, keeping up with the benchmark may be an indicator of pro-risk behavior.