Howard Marks is well known to many investors but here is the recap: he is the Co-Chairman of Oaktree Capital, an alternative asset manager with US$193 billion in assets, and his regular memos are widely read by professional investors and average punters alike.

In his latest memo, Marks discusses his visit with clients in Australia last month and presenting his ‘sea change’ idea—that interest rates won’t go back to the lows seen over the past decade and that portfolios will need to adjust accordingly.

Marks has been pushing this thesis for a while, so there’s nothing new there. However, his presentations led to broader discussions about asset allocation, and from that he had two epiphanies on the topic.

Rethinking the two major asset classes

Marks suggests that ‘asset allocation’ is a relatively new phenomenon. No-one used the term when he joined the finance industry 55 years ago, and portfolios then generally followed a standard 60% equities, 40% bonds split. For US investors, that meant simply allocating to US stocks and bonds.

Now, investors have far more choices. In the types of assets they can invest in - debt, real assets, venture capital, private assets and so forth. In the countries that they can put money into—developed markets versus emerging, home versus abroad etc. And in the ways that they can try to increase returns - including levered strategies and putting more into ‘high beta’ assets.

What struck Marks in Australia though was that despite all the choices, there are essentially only two asset classes: ownership and debt. By this he means that if you want to participate financially in a business, the choice is between a) owning part of it, or b) making a loan to it.

You may think that these two choices are just between stocks and bonds. They’re more than that. Ownership assets can include common stocks, whole companies, real estate, private equity, and real assets, while debt can include bonds, loans mortgage backed securities, and other streams of promised payments.

Marks says ownership and lending have fundamentally different characteristics.

Owners put their money at risk with no promise of a return. They buy a piece of a business or asset and are entitled to a proportional share of any profit or cashflow made. Ownership assets typically have a higher expected return, greater upside potential, and greater downside risk.

Lenders, on the other hand, provide funds to help owners purchase or operate businesses or other assets and, in exchange, are promised periodic interest and the repayment of principle at the end. It’s a contract between borrower and lender, and the resulting return for lenders is known in advance. It’s called fixed income because it’s a fixed outcome.

All else being equal, the expected returns from debt are lower than from ownership assets but likely fall within a tighter range. There’s generally no upside on debt as you buy an 8% bond to make an 8% return. Yet, there’s also minimal downside as you’ll get the 8% return if the borrower pays, and most do pay.

Marks says that when building portfolios, investors have a choice of ownership assets and debt, and how much to allocate to each:

“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 best framework for asset allocation

The second epiphany that Marks had in Australia was about the basic characteristics of a portfolio. He says one decision matters above all else in allocating assets: the desired mix between aggression and defence or between preserving capital and growing it. Aggression is usually best played through ownership assets, while defence is better played through debt.

Marks believes that you typically can’t play offence and defence at the same time; they’re mostly mutually exclusive. "This is the fundamental, inescapable truth in investing", he says. And the choice you make between offence and defence will determine the risk profile of your portfolio.

When thought of this way, the goal of investors shouldn’t be achieving the highest return for a portfolio, Marks thinks. Instead, it should be achieving the highest risk-adjusted return, with the right mix between offence and defence to suit your wants and needs:

“For an investment program to be successful, the level of risk in the portfolio must be well compensated and fall within the desired range … neither too much nor too little.”

Concluding this second epiphany, Marks says:

“Ownership assets and debt assets should be combined to get your portfolio to the position on the risk/return continuum that’s right for you. This is the most important decision in portfolio management or asset allocation.”

Talking his own book

Marks also uses the opportunity to talk up one of his company’s preferred sectors right now: non-investment grade credit. He suggests while the returns on offer were better a year or two ago, you can still get roughly 7% on public credit and 10% on private credit. Marks thinks these returns are competitive with the historical returns of equities, but without the risks associated with owning equities. And because of their contractual nature, the returns on credit should prove more dependable than those of ownership assets.

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