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I am an avid follower of the memos of the veteran fund manager Howard Marks of Oaktree Capital Management. I wanted to share a recent memo of his regarding asset allocation in which he ruminates on the differences between credit investments and equities. You will often hear wealth managers talk of 60/40 portfolios which splits investments between equities and bonds and I thought it would be helpful to describe what this really means.

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As Marks explains, if someone wants to participate financially in a business, the essential choice is between owning part of it and making a loan to it. For investors, this will usually be in the form of buying into either an equity-based fund or one that invests into corporate and government bonds as part of a balanced portfolio. As such, investors may think of stocks and bonds as falling under the same heading, but the difference between the two is enormous – ownership and lending have nothing in common.

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Owners put their money at risk with no promise of a return. They acquire a piece of a business and are entitled to a share of the profits. Lenders typically provide funds to help purchase or operate a business and other assets and in exchange, are promised a rate of interest and a return of the capital at the end of the term. The relationship between borrower and lender is contractual and this is why it is often referred to as “fixed income.” 'Ownership' assets (such as shares, whole companies, real estate, private equity and real assets) and 'debt' (bonds, loans, mortgage-backed securities, treasuries) should be thought of as entirely different.

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Ownership assets typically have a higher expected return, greater upside but also greater downside. Everything else being equal, the expected returns from debt are lower. There is generally less upside or downside. No one should buy a bond yielding 8% expecting to make more than that over the long term.

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So how should these two elements be used in creating a portfolio? Howard Marks' opinion is that it is based entirely around how aggressive, or defensive, an investor is with regards to their attitude to risk and volatility. If insistence on preserving capital is the desired outcome then taking a more defensive stance will preclude pursuing maximum growth. Correspondingly, a decision to strive to achieve maximize growth means preservation of capital must be sacrificed to some degree.

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It's one or the other. One cannot be both offensive and defensive. Portfolio construction is therefore about optimization, not maximization. Wealth should be pursued in an appropriate way taking into account an investor’s wants and needs. Some believe the proper goal should be to get the highest return but actually the goal should be to achieve the best relationship between return and risk, often described as searching for “superior risk adjusted returns”, or the profit that can be made relative to the amount of risk one is willing to take. The aim is that this leads us to invest in assets whose expected return is more than sufficient to compensate for the risk and this will vary between different individuals.

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Which of the two is better, ownership or debt? No one can say. A higher expected return with further upside potential, at the cost of greater uncertainty, volatility and downside risk? Or a more dependable but lower expected return, entailing less upside and less downside.

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Of course the skill of the investment manager is to combine the two elements to protect and increase the value of your investments over the longer term. No two investors are the same and that is why we offer tailored strategies for our clients, not a one size fits all approach.

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Comments from James Scott-Hopkins, Founder, EXE Capital Management

The views are those of the author only. The value of investments can fall as well as rise. Past performance is no guarantee of future returns.‍

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