Below is Part 2 of PM Jar’s interview with Howard Marks, the co-founder and chairman of Oaktree Capital Management. In the excerpts below, Marks discusses his approach to the art of investing: transforming symmetrical inputs into asymmetric returns. Be sure to read Part 1: An Idea of What Is Enough.

Part 2: Real World Considerations

“You shouldn’t care about volatility intellectually, but there are real world considerations.”

Marks: Client selection is important for professional money managers. You should tell them before they sign on what you’re going to do, what you’re not going to do, what you can do, what you can’t do. For example, we tell our clients, “When the markets boom, we’re not likely to beat the market. If that’s what you want, don’t come to us.” You can influence your probability of success with clients by putting effort into educating them. This way, they are ready for you to take contrarian actions (to buy aggressively when the world is collapsing and to sell aggressively when the world is soaring). I tell them what they can and can’t expect. The ones who don’t want what we can offer turn themselves away. Saying to every client “I can give you whatever you want” is not the foundation for a successful business.

PM Jar: Would you advocate diversification versus concentration of one’s client base?

Marks: I think it’s preferable that you don’t have all your money from one client. That’s not a good business model.

PM Jar: In your book, you discuss volatility. When markets are good, people say they don’t care about short-term fluctuations. When things get bad, volatility becomes dangerous because of the impact it has on the human mind, causing people to do the wrong things like selling securities or redeeming from funds at the wrong time. Do you think fund managers have an obligation to keep clients from being their own worst enemy, such as trying to keep volatility lower in the portfolio so as not to cause clients to make irrational decisions? 

Marks: You shouldn’t care about volatility intellectually, but there are real world considerations. It’s very hard to predict volatility. You should only have an amount of risk in the portfolio that your clients can tolerate. It really comes down to the six-foot tall man crossing the river. If you stick your nose in the air and say, “I don’t care about how bad things might get in the interim,” you can subject your clients to risks they can’t afford, which can lead them to sell out at the bottom. On the other hand, what you’re describing is sub-optimizing, and doing clients a disservice by not pursuing the best returns. In a way, you have to do both.

If you have open-ended funds, one way to help your clients would be to hold their hands and keep them in the market so that they will not turn a downward fluctuation into a permanent loss by selling out at the bottom, and thus failing to participate in the recovery. If you have locked-in money, you don’t have to be worried.

No investment vehicle should promise its clients more liquidity than is afforded by the underlying assets. But a lot do. Each manager has to figure out, to his own satisfaction, what he should give the client that would represent doing a good job. One of things that we’ve always thought important is when operating in illiquid markets subject to bouts of chaos, it’s better to have locked-in money. Because then, you can do the right thing. We want to be able to do the right thing. And we want to help our clients do the right thing. 

Continue Reading — Part 3 of 5: The Intertwining Debate of Diversification and Concentration