Einstein once said, “Everything should be made as simple as possible, but not simpler”. This bit of wisdom works exceptionally well in so many areas of life, but it is particularly good advice for investing. Unfortunately, most investment firms do not heed this advice when constructing portfolios for their clients, building all kinds of unnecessary complexity into them. Perhaps it is human nature to believe that a more complex solution is better in investing, that a simple solution cannot possibly be as effective. While the point at which additional complexity adds no incremental value is debatable, adding complexity always increases costs, reduces transparency and control, and sometimes hampers liquidity, all of which are bad for the investor. Therefore, a close examination of the level of complexity found in each and every portfolio is always a good idea.
Consider hedge funds. People with enough wealth to qualify as hedge fund investors often want them in their portfolio. Many think of hedge funds as magical structures that offer investors high, uncorrelated returns with low risk, although the data on them do not support such a view. There was a very good article this weekend in the Financial Times that discusses how many of the risks to hedge fund investing are overlooked and that the expected high returns and low correlations are fleeting, especially after considering fees and taxes. The article also cites another bit of research that concludes that investors in hedge funds actually earn 3-7% less than what is published because of the timing of cash flows in and out of them. Most investors only invest in a hedge fund after it is able to post exceptional returns, but those returns rarely persist and so investors don’t experience performance that matches their reason for investing in the hedge fund in the first place (incidentally, this is the case in mutual fund investing, too).
Investors may be catching on, however. Institutional investors, those large pension funds and endowments who have been regular clients of the hedge fund industry, are rethinking their exposure to this and other complex areas of finance and are reallocating substantial portions of their portfolios to passive strategies in an effort to make things “as simple as possible, but not simpler”. Interestingly, many hedge fund managers are themselves throwing in the towel. Most recently, Stanley Druckenmiller, a legend in the hedge fund industry, bowed out after determining he is unlikely to be able to meet return expectations going forward.
But this post is not meant to be an indictment of the hedge fund industry, per se. The true enemy to the Einsteinian investment model is the investment industry itself. In order to feed its own need for high profit margins to pay for the existing armies of salespeople, consultants, and analysts, as well as to keep everyone in opulent office space, offer outrageous pay packages to executives, and pay fines to the SEC, the industry must keep complexity the name of the game. It is impossible for the industry to charge what it currently charges for investment services by selling what I argue is a far more rational and effective approach to the markets. So, when you are introduced to the latest and greatest must-have additions to your portfolio – hedge funds, commodities, gold, currency and interest rate hedging vehicles, structured products, unified managed accounts and overlay strategies – make Einstein proud and get a second opinion from a knowledgeable and credible source. Chances are your portfolio will fare much better without the additional cost and complexity that those things bring with them.