READ THE ORIGINAL
Published in full and free by Oaktree Capital Management. This page indexes its arguments; it is not a copy.
THE ARGUMENT
Marks sat in on a US state pension board reviewing its own investment process with its consultant, and writes up what was asked and how the board answered. It is his clearest statement that volatility and risk are not the same thing — volatility bites through externalities particular to a given investor, not through the asset — and that no standard for judging an investment operation is free of defects. His practical conclusion is that any assessment period shorter than a full market cycle rewards risk tolerance and calls it skill.
What it actually claims
The consultant’s frame he found most useful sets a plan’s financial ability to bear risk against its willingness to bear it; the cell he dwells on is low ability with high willingness, labeled naive, which he thinks is a generous word for taking risk you might not survive. He reads his own decision at Penn through it: with the endowment lagging in 2000 after being underweight growth, tech, venture and buyouts through the 1990s, he argued against turning aggressive, because underperforming from an elevated market level was the smaller risk set against joining a bust having already missed the boom.
The board he watched accepts that its conservatism will cost it in strong markets and prefers that to the alternative — and accepts that real diversification means there may well be laggards in the portfolio at all times.
- 100% of board members agreed — half strongly — that exposure to risk is necessary if the plan is to meet its objectives
He is most struck that beating peers came last among the plan’s objectives, and argues that a defined benefit plan succeeds only by paying benefits at minimum cost to the sponsor — while a plan that does pay them has not thereby proved skill, since the environment that happened to unfold may have carried it.
- outperforming peers ranked fifth of five possible objectives
- the Sharpe ratio ranked last among six possible performance metrics
His argument on volatility is that it is not the risk long-term investors should care about — permanent loss is — and that the reasons people fear price movement are situational, career-related and emotional. Since the same holding is risky for a daily-priced fund and not for a sovereign wealth fund, the risk sits in the investor’s circumstances rather than the asset; a public bond and a private loan from the same issuer carry identical default risk and only one marks to market.
- Buffett would rather earn a lumpy 15% return than a smooth 12%
On portfolio construction he endorses the board’s appetite for leverage and illiquidity as reasonable for a well-funded plan, with the caveat that the lender can withdraw the leverage at exactly the wrong moment and that borrowing raises the bar for every low-returning asset held.
- a substantial majority comfortable using leverage at 15-20% of plan assets
- a slimmer majority backing 25% of the portfolio in illiquid assets
He lays out the paradox at the center of performance assessment: the actuarial return is the only thing that matters in the long run and tells you nothing in any single year, so the short-run yardstick has to be a relative one — yet matching peers in a frothy market may only prove you were as imprudent as they were, and the policy portfolio lets whoever set it off the hook.
- a 6¼% actuarial assumption
His answer on the assessment period is that no fixed number of years will do — it has to span both good times and bad, because a stretch of uninterrupted good years hands the top marks to the most risk-prone portfolios and cannot distinguish skill from a standing bias.
- the last 16 years, save for a few relatively short dips, have been good times
Figures are the author's own, as cited in the memo.