Today, I'll take a different approach. Rather than simply shaking my fist at the sky hoping that will improve returns, I want to focus on this too-common reach for complexity as the solution to investment problems and to suggest that instead we should strive, wherever possible, for simplicity. Or rather for as much simplicity as possible — but no more. Think of it this way: The simplest possible portfolio is just cash, but you can only do that when you are fully funded and have no chance of missing your goals. If you're not there, you need to get more complicated — adding asset classes as you go, adding active management, adding more complicated or abstruse asset management and asset classes. Each time you're doing that you should be thinking "Do I need to do this; am I sure I know what I'm doing; do I have the governance in place to do this?"
Now, it's important to note that complexity has an important role in what we all do. The firm where I work has many highly sophisticated investors as clients, with deep and expert investment staff and the capability to really dig into and understand the implications of complexity in their portfolios. Working with them on that process is an important part of what we and our competitors do. But it's important to note that being able to understand and manage complexity is different from assuming that complexity will provide investment solutions that will solve every problem when capital markets are unpromising — and that is often the feeling that you can get when you hear the latest investment strategy being described and proposed as the solution to investor challenges.
The important point to remember is that complexity is rarely a benefit in itself and is often precisely the opposite. Complex solutions are harder to understand and the ways they are likely to behave in different circumstances can be hard to model. Complicated solutions can, in fact, solve some investment problems, but investors need to be able to very clearly define the particular problem being solved, and then be able to perform effective analysis to confirm that the proposed solution does in fact solve that problem. An example is adding derivative-based strategies to the portfolio. That can be helpful in a number of ways — helping change the shape of your returns, protecting against downside, adjusting your risk exposure — but you have to be sure you understand the exposures you are putting into the portfolio and that you can measure what success and failure look like.
What complexity tends to be bad at doing is solving the big building block problems of portfolio management.
What are those big building block problems? There are three of them. First, interest rates are very low: this means that bonds no longer provide much of the free protection against downside that they previously did. It also creates the second and third problems: that valuations of risk assets are generally high (due to low discount rates) and therefore expected returns from those asset classes are generally low, and that the present value of liabilities are also generally high (for the same reason).
Wind the clock back 30 years and those three big basic building blocks of portfolio math look much more congenial: rates were much higher, valuations had a way to run and liabilities had a smaller present value. As the markets have moved from this (delightful) state of affairs to the one we are all in today they (the markets) have, of course, allowed market participants to point to the positive return outcomes those market moves have generated as evidence of the investor's genius.
Complex solutions can help with some of the challenges this environment poses — but generally the help they can provide will be in particular areas of the portfolio rather than changing the big characteristics of the portfolio as a whole. And ensuring that the complex solution does what it is supposed to do requires investment skill and resources. Adding a well constructed hedge fund portfolio, for example, might help drive better risk adjusted return — and in some cases may even provide a boost to total return – but doing so requires skill in both manager selection and portfolio construction, as well as the ability to provide ongoing oversight of the portfolio and the understanding to know when to adjust exposures. That governance structure is key to success.
I suspect it is better to think about complexity in the same way as we often think about illiquidity. The idea of the "illiquidity premium" is a poor way of thinking about illiquidity, and in the same way the idea of a "complexity premium" is foolish. Both illiquidity and complexity have their place in portfolios — but they are both risks, rather than sources of return. Both illiquid and complex portfolios can produce good outcomes — illiquid portfolios, managed skillfully can produce excellent returns, while complex portfolios can produce tailored outcomes — but they can both also produce real challenges that can threaten the chance of the investor achieving their goals.
This analogy works well in another dimension. Illiquid portfolios need good governance — there needs to be good initial due diligence, and good ongoing implementation, with many eyes watching how the portfolio is developing, and with a focus on what can go wrong, with plans in place to identify when that is happening and to forestall it.
Just as when considering illiquidity, investors should think hard about adopting complexity as a core part of their portfolio. For larger, deeper staffed and more sophisticated investors there may be opportunities that involve complexity that can help shape returns, dampen risks or build more attractive properties into the portfolio — but for many investors the potential downside is greater than the potential upside. Complexity carries a burden of time and potential trouble, and it carries both opacity and (usually) higher fees.
And that is where we can usefully focus at the end of the day. Complex solutions are often sold not bought, and are often more expensive than tried-and-true, more simple solutions. The best approach is for investors to ensure that they know what the complexity included in their portfolio is there for, and what success and failure look like, and what good governance looks like in the context of that complexity. Focusing to make sure that the portfolio is as simple as it can be for the goals they want to achieve — but no simpler — can help investors ensure that every fee dollar is well spent, and that the probability of unpleasant surprises is reduced. Simple is often better.
Ian Toner is CIO of Verus Advisory, based in Seattle. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.