Howard Marks is famous among many investors for his Client Memos as the chairman and cofounder of Oaktree Capital Management. He even weaved many of the older ones into a book, which I read and reviewed. I now try to read every one that comes out. Here’s the most recent client memo dated November 26th, 2013 [pdf]. Below are a few selected excerpts. First, a quick lesson on risk aversion:

Risk aversion is the essential element in sane markets. People are supposed to prefer safety over uncertainty, all other things being equal. When investors are sufficiently risk averse, they’ll (a) approach risky investments with caution and skepticism, (b) perform thorough due diligence, incorporating conservative assumptions, and (c) demand healthy incremental return as compensation for accepting incremental risk. This sort of behavior makes the market a relatively safe place.

In short, it’s my belief that when investors take on added risks – whether because of increased optimism or because they’re coerced to do so (as now) – they often forget to apply the caution they should. That’s bad for them. But if we’re not cognizant of the implications, it can also be bad for the rest of us.

What about now? Marks does see an increase in risk tolerance recently. But how bad is it?

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How time flies. Almost exactly 5 years ago on November 21st, 2008, I was sitting alone in yet another hotel on a business trip in a city that I can’t even remember. CNN was on TV as I wrote the following in a blog post with the title S&P 500 at 750:

While the present looks bleak, the potential for future returns is looking brighter and brighter for long-term investors. The opposite was true a few years ago. If you’re young and still putting money away, this is a good thing! (Although adequate emergency funds should be your first goal.)

Here are selected comments on that post that I admit gave me some doubt:

However, EPS estimates, and therefore valuations, are ridiculously high.

Putting money into a market that represents the old model right now seems like pure folly.

This bear market will last 3-12 years!

I think it’s funny that many of you are down 50% and think that you will break even in a few years, or justify by saying “I’m for the long term”. […] Also, most of the dividends being advertised are based on fantasy (again), just like the EPS, because companies will be cutting them a lot to survive. So no, the S&P isn’t cheap to buy and buy-and-hold is really dead.

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Speaking of holding municipal bonds, I’ve been catching up on the troubles in Detroit and Puerto Rico. Last month, there was a flurry of articles warning about mutual funds with high exposure to Puerto Rico bonds, as they were yielding over 9% and trading at 60 cents on the dollar. Most junk corporate bonds don’t yield that much! Yet, they still clung to investment-grade status from the major ratings agencies because if they went any lower, the bonds would crash as many mutual funds would be then forced by their mandates to sell the bonds. Don’t you love ratings agencies?

From NY Times:

For example, the $34 billion Vanguard Intermediate Term Tax Exempt fund [VWITX], the biggest muni bond fund, lost more than 5 percent from May through August. And the largest exchange-traded tax-exempt fund, the $3 billion iShares National A.M.T.-Free Muni Bond fund [MUB], lost 8.3 percent in the same period. […]

In late August, it was Puerto Rico’s turn to roil the market. A Barron’s article detailed the territory’s high debt load and an economy that wasn’t producing enough revenue to easily cover that debt. The S.& P. Puerto Rico municipal bond index fell 10 percent over the next two weeks before the bleeding stopped. Still, the index was down 16.4 percent in the first nine months of the year.

As of 11/19/2013, Morningstar reports the trailing YTD total return of MUB was -2.97% and VWITX was -1.43%. From Reuters:

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I would characterize my personal portfolio as 85% passive, 15% active, and 100% low-cost. Why is part of my portfolio managed by people trying to generate “alpha”? Aren’t I supposed to say that index funds are always better? Author and money manager Rick Ferri has a good post about When Active Funds Makes Sense, even he is a well-known index fund advocate.

Here are a few circumstances when I consider an actively managed fund over an index-tracking product:

1. The absence of a diversified low-cost index fund or ETF that tracks the asset class.
2. An active fund is lower in cost than an equally diversified index fund.
3. An active fund has greater diversification than an index product, even if the fee is slightly more.
4. The unique risk I am trying to capture is better suited to active management than in an index-tracking product.

He then discusses in detail a few categories that satisfy these conditions: municipal bonds, high-yield corporate bonds, and value stock strategies. I was particularly interested in the muni bonds part:

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This Vanguard article included an infographic (see below) that shows the growth of international bonds as an asset class. If you were to consider the world’s investable market as split between bonds and equities, internationally-issued bonds are now the largest piece of the pie at 35%. This includes both government and corporate bonds.

Vanguard believes that holding international bonds is an important way add diversification to your portfolio, and in mid-2013 added international bonds to their Target Date Retirement and LifeStrategy all-in-one mutual funds (currently 20% of the total bond allocation). The Vanguard Total International Bond Index Fund Investor Shares (VTIBX) has an 0.23% expense ratio. I’m still not convinced of their necessity and don’t own any foreign bonds. Back in 2000, international bonds were still 19% of the global market, yet they took up 0% (none) of their Target Retirement and LifeStrategy funds.

I previously wrote about how the Vanguard Balanced Index Fund was a good example of the benefits of holding both stocks and bonds in your portfolio. Now, I’d like to extend this and compare the Vanguard Balanced Index Fund (VBINX) with another veteran balanced fund, the Vanguard STAR Fund (VGSTX). They are similar yet different:

Here’s a chart of how $10,000 invested 10 years ago would have done. With the Vanguard STAR fund, you’d have $20,653 today. With the Vanguard Balanced Index fund, you’d have $19,749. (This is with Investor shares, which have a lower minimum investment than Admiral shares. The minimum used to a lot higher, but now it is $10,000 for Admiral shares.)

(click to enlarge)

My observations:

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