Brent Sheather: Investing complexities are a myth

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There are a number of myths about investing. Perhaps the most profitable of these is that investing is complicated and the more jargon you use the better.

In the investment world a general rule is that the higher the level of complexity the higher the level of fees that can be charged hence all the players interest in advocating complex solutions to simple problems. Reality however is that a profitable investment strategy is almost always anything but complicated, especially for retail investors.

The big decision is asset allocation and there are only three asset classes to choose from, for goodness sake. Furthermore despite the hype about tactical asset allocation from fund managers and consultants, the right mix hasn't changed much amongst professional investors for about thirty years.

It is also probably fair to say that if investing was indeed complicated there wouldn't be many financial advisers and stockbrokers involved! Recall the old joke that stockbrokers are frequently would be accountants who didn't make the grade. Incidentally by the end of stage two at Waikato it was pretty obvious that accounting wasn't for this fool either.

Anyway it is pretty clear that the finance industry is intent on perpetuating the myth that investing is complex in much the same way that airlines run out the ridiculous notion that air travel is fun. Both ideas are farcical. This week's story is about a recent report, predictably written by a fund manager, which made a rather poor attempt at arguing that investing is complicated.

So let's have a look at the arguments for complexity and then destroy them. The article starts by saying that twenty years ago investing was indeed simple but today is complex because back then investment options were limited share investment was limited to long only, benchmark relative exposure and dynamic asset allocation techniques hadn't yet been dreamed up. Today, in this more enlightened age, the author contends that only a naïve investor wants to buy and hold a portfolio based on index weightings.

An on the ball investor owns all manner of exotic vehicles to derive his or her equity exposure including long/short, market mutual, buy/right, absolute return, low beta/low volatility etc styles of strategies. Really? I don't think so. Most retired retail investors want to own equities with the objective of accessing a rising income stream and ensuring that the capital value keeps up with inflation.

One only has to look at the huge popularity, overseas anyway, of basic long only, capitalization weighted exchange traded index funds to see that simple and low cost resonates with a lot of people with money. In 2011 twice as much money went into passive funds as went into active funds, according to Morningstar.

The common denominator with the esoteric equity exposures as described above is that they cost much, much more to access in terms of the annual management fee and are frequently burdened with a performance fee as well. Fees wouldn't be an issue if they were reasonable relative to returns but even your bog standard international share fund with prospective returns of 6% pa has a management expense ratio of typically around 1.5% so that is 25% of returns up in smoke. And that is before performance fees.

The other big downside of complex investment strategies is that specialization has the effect of allowing investors perennial bad timing choices to adversely impact results. Research shows that retail investors almost always embrace a particular investment strategy after it has achieved high returns with the effect that subsequent returns are low. A broad based approach to investing minimizes the impact of this silliness.

An example will illustrate back in 1999 technology stocks were all the rage and people who bought specialist technology funds are still hurting whereas investors who bought the whole market have fared less badly.

Often complex investment strategies achieve nothing except additional costs. I saw a particularly ridiculous example of specialization the other day a financial advisor had recommended two US index funds. One invested in growth stocks and the other invested in value stocks. What was the net result the client had an exposure to the broad market which could have been more easily and much more cheaply achieved by buying the broad market version of the fund.

The love of complexity is not just confined to fund managers financial advisers are in on the act as well. In an article the other day three financial advisers were interviewed as to how they determined a client's risk profile. Two of the three proudly declared they used Monte-Carlo simulation techniques to get to grips with the subject.

Goodness me talk about using a computer to open a tin can. Fortunately it doesn't look like the FMA will be seduced by this behaviour they are on record as saying words to the effect process is nice but what counts is the outcome for investors.

Reading between the lines what this means is financial advisers can't blame the Monte-Carlo model if they put their client into finance company debentures again. Incidentally I used Monte-Carlo simulation models to factor uncertainty into financial models back in 1981 but from memory it didn't really add much to the decision and if it is not essential when you are spending US$500 million it is probably equally as redundant when investing NZ$200,000.

At the end of the article the fund manager justifies his advocacy of complexity when he quotes Albert Einstein as saying things should be made as simple as possible but not simpler. It is probably safe to say that Albert would object to his words being hijacked like this. There is a linear relationship between cost and complexity with no obvious payoff in extra returns.

A Senior Visiting Fellow of the Pensions Institute of the Cass Business School was quoted the other day as saying there is little academic evidence that asset management and the potential for outperformance is more important than cost. That is exactly why passive funds are attracting new money at the expense of actively managed funds.

The fund management industry needs to go back to basics and focus on what investors need rather than what they need. Investors require an income that rises with inflation and the inflation proofing of their capital with minimal volatility.

The broad stockmarket has historically satisfied these objectives and is likely to continue to do so however esoteric strategies almost always increase risk and always increase fees with the effect that more often than not the basic requirements of investors are compromised.

Coincidentally John Kay touched on this issue in the Financial Times recently when he wrote the deeper issue is that complexity is intrinsic to the product many money managers sell. How can you justify high fees except by reference to frequent activity, unique insight and arcana?