Tuesday, January 18, 2011

Howard Marks – April 2001 Memo: Safety First . . . But Where?

As is usual from Howard Marks, this 2001 letter was full of wisdom. A few things I found extra interesting are below (Marks’ excerpts are in blue).

In the discussion about the prices of certain assets, I thought the third bullet point in the government bond section below was especially interesting to see. What a difference 10 years later:

Second, government bonds are quite highly priced today, thanks to:

 the flight to quality that resulted from the pain in the stock and high yield bond markets,

 the current low level of inflation, and

 the looming scarcity of Treasury securities as budget surpluses erase the Federal debt (I'm not quite sure I buy that one).


Marks’ definition of alpha:

To me, alpha is skill. It's the ability to profit from things other than the movements of the market, to add to return without adding proportionately to risk, and to be right more often than is called for by chance.

More important, alpha is differential advantage; it's skill that others don't possess. That's why knowing something isn't alpha. If everyone else knows it, that bit of knowledge gives you no advantage.

Lastly, alpha is entirely personal. It's an art form. It's superior insight; some people just "get it" better than others. Some of them are mechanistic quants; others are entirely intuitive. But all those I've met are extremely hard working.

You want managers who have alpha, and you want them to be working in markets that permit it to be put to work. Only in markets that are not efficient can hard work and skill pay off in consistently superior risk-adjusted returns. I always say if you gave me 20 Ph.D.s and a $100 million budget, I still couldn't predict the coin-toss before NFL games. That's because it's something into which no one can gain superior insight. When someone says "my market is inefficient" or "I have alpha," make him prove it.

You want to be sure the claimed alpha is there. Just about everyone in this business is intelligent and articulate. It's not easy to tell the ones with alpha from the others. Track record can help but (a) it has to be a long one and (b) it's still possible to play games.

My advice to you is that when you find managers who do what they promise and seem to do it well, stick with them. Even the best manager won't be infallible, but staying with those who've demonstrated skill and reliability will reduce the probability of disappointment.


And a prescient prediction about hedge funds:

I expect hedge funds and absolute return funds to be promoted heavily by brokerage firms, mutual fund organizations and investment advisers and to become the next investment fad.

Link to 2001 Memo: Safety First . . . But Where?