Wear a Mask if you Invest in Crowded Spaces

Do markets look expensive or attractive? How much risk should one take and where? A recent piece, Coming into Focus, written by Howard Marks provides an excellent read and appreciation of the current environment. He argues that, given where rates are, that current valuations may well be justified. But he also adds a strong note of caution, which is that prospective returns have never been lower. This basically leaves an investor with the choice to: a) invest like he has always done and settle for lower returns b) be defensive and settle for even lower prospective returns c) go to cash and wait for better times d) achieve higher returns by increasing risk e) increase investments in specialist managers in search for alpha.

The options presented by Howard Marks are clear but the question is; do allocators such as advisors, endowments, pension funds and asset managers really have the same options? Do they have the luxury to stay in cash, knowing that their future liabilities only continue to increase? Can they really boost risk in search for higher returns, knowing that this may result in an even larger shortfall? Most institutional investors will therefore be gravitated towards a combination of a) and e) whereas a) is the beta of their portfolio and e) the alpha.

So, what is the alpha and where can you find it? There are various views and specialists but are there common denominators to find alpha opportunities? There are of course many but let’s just take a few: a) to generate returns that are not a function of market risk, research is key. Be better in the area you cover and digging deeper will be a key denominator in achieving that. Cristiano Ronaldo, world’s top soccer player would stay after trainings to practice and improve his many moves while most of his teammates had left for the day, just to ensure he could compete and win. b) Identify where capital is most efficient and avoid those places as it will be hard to make a difference. Also, you’ll be competing with banks, large allocators and the rest of the herd. Achieving alpha by not deviating from a benchmark is of course not possible. c) Be opportunistic, shift your allocation. Inefficient markets will end up drawing attention and become efficient. d) Be mindful of size as scalability of alpha has a limit. Ask a 3-star Michelin Chef to prepare his meals for five thousand people instead of fifty and see how they reacts.

The credit markets are highly efficient for a great part as many allocators with scale are drawn to the same areas in search for a yield pick-up. Interestingly there is a strong undercurrent of inefficient credit markets which is growing as a consequence of COVID. Go to a bank and try to refinance a hotel asset, or tell them you would like to buy a couple of office buildings opportunistically. Banks are increasingly careful, as profitability of each transaction is low, while the closing costs are high. They therefore try to minimize the latter while optimize the former and this leads banks to avoid even slightly tailored transactions. The current environment unfortunately has also impacted many borrowers. Despite their sometimes-precarious short-term cash situation, their assets may provide solid collateral for asset-based lending especially if you are able to incorporate the right safety features.

In certain parts of the credit markets, the room for specialists who deploy their experience and don’t mind the effort arbitrage is much greater than before. But similar to today’s world of COVID, the same advice should be applied; avoid hanging out in places with large crowds (especially those places where people get euphorically drunk on high asset prices) or at the very least, if you do, be risk-conscious and WEAR A MASK!