Howard Mark INTERNAL Memo: Lessons Learned from Leverage

Via ZeroHedge: Howard Marks of Oaktree wrote another memo in March, addressed only to clients and their consultants, in which he detailed his funds' failures at using leverage in 2008.  The money quotes for me:

• There's a big difference between value investing and absolute-return investing, and we've learned it fully.  A fund that's truly capable of consistently producing positive results may be well-suited to leverage.  On the other hand, even though value investing represents the best way to achieve excellent results in the long term, it's still subject to large enough short-term fluctuations that the use of leverage has to be examined critically.  It's interesting to note that the Emerging Markets Fund, Oaktree's only absolute return fund, achieved positive returns in 2008 even though it relies on leverage to let it hold long and short positions exceeding 100% of its equity capital.

• Finally, once you decide to lever a fund, "risk management" becomes more important than "portfolio management."  Many more people know how to pick securities than know how to restrict a levered fund's risk to the amount that can be withstood.  And the ability to pick securities for an unlevered fund isn't nearly as critical as the ability to manage risk in a levered fund.

End of excerpt

The first statement--"There's a big difference between value investing and absolute return investing"--is one you seldom see emphasized in hedge fund marketing documents.  There is, it seems to me, almost a Montague vs. Capulet-level divide between the goals of value investing and those of absolute return investing.  If one's goal is the best results in the long term, Marks argues that value investing is your best bet.  But the price to be paid for this goal is the willing acceptance of short-term performance fluctuations, fluctuations that almost always render impossible the long-term use of leverage.  If one's goal on the other hand is absolute returns--consistently positive results--then leverage is more appropriate but it forces you to eliminate from the universe of things you look at the value investing opportunities that produce the best long-term results.

My sense is that many long-short hedge fund managers who call themselves value investors try too hard to walk this tightrope: they seek the blessings that come from being known as a value investor while also promising the consistently positive results they feel institutional investors require. 

Comments

[Brian]

I could not agree more. Very interesting post.