Why simple portfolios fail to deliver for investors

Simple portfolios may make investors feel good but may well fail to deliver or meet expectations, writes Dominic McCormick.

At the recent PortfolioConstruction conference a number of speakers pushed the case for ‘simpler’ investment portfolios. Given similar comments and articles in the media, it seems that many investors and advisers share this sentiment.

While these ‘simpler’ or ‘vanilla’ portfolios are not always clearly defined, they suggest some or all of the following: fewer investments and asset classes in portfolios, more in large, brand name fund managers/investments, a focus on passive/index approaches, using liquid investments only and investing little or nothing in alternative assets and strategies.

To some it also involves the reliance on a ‘set and forget’ strategic asset allocation approach (the problems of which I highlighted in my last article, “Portfolio management in the real world”, Money Management, 20/08/09).

There is no doubt that plenty of investors, advisers (and regulators) are clamouring for simplicity, and it is difficult not to have some sympathy with this view.

The investment world has become excessively complex, with arguably too many financial instruments and available products. At some point, staying on top of this complexity requires significantly increased due diligence and a greater risk of some of these going wrong.

Tidying up unwieldy portfolios to be more focused makes sense.

However, should advisers blindly accede to client demands for simple portfolios without properly considering all the pros and cons?

Is pursuing simplicity above everything else the best response to the current investment environment?

Or is it a response designed to make investors (and advisers) feel better without helping, and perhaps hindering, long-term returns?

After all, it was not product or portfolio complexity itself that caused many of the problems. Further, it’s not as if simple portfolios have been immune from the global financial crisis.

Sure, a number of products that disappointed investors were complex (eg, funds investing in collateralised debt obligations or large fund of hedge funds).

But it is the inherent characteristics of these problem products, such as bad structuring, overvalued assets, liquidity mismatches or excessive gearing, that were the key issues.

Indeed, many of these same features were present in products or strategies deemed (at least in the past) to be relatively simple.

For example, standard mortgage or direct property funds have disappointed because of the liquidity mismatch (and overvaluation of property).

Gearing into index funds is a fairly simple strategy, but some people’s lives have been destroyed by it.

Listed property trusts (LPTs) were a simple investment that became both overvalued and structurally risky (and ultimately complex) over time. It is only in hindsight that many of these once relatively simple products and strategies have been deemed complex.

It is true that the higher costs of some complex products are an additional hurdle that impacts returns (especially if these higher costs relate to distribution/marketing costs rather than payment for investment added value).

But it is worth noting that some complex (and costly) investments, such as managed futures and volatility funds, were among the few to perform well in 2008.

This is the nature of investing. Complexity and simplicity are partly in the eye of the beholder. One period’s simple product becomes complex in another.

Other elements of the investment industry are complex and always will be.

However, there is the important question of where the complexity lies and who should be responsible for it.

Investing in a few blue chips might seem simple, but how many investors really understand the intricacies of Telstra or the banks? Multi-manager funds may invest in complex areas, but they can still be a simple product for investors. The key is having confidence in the people making decisions about these complex areas.

The problem with overly simple portfolios is they cut down the opportunity set in ways that can severely inhibit the building of robust investment portfolios. Issues that confront such simple portfolios include the following.

By nature, simple portfolios are diversified across fewer risks and are typically heavily exposed to equity risk (if growth oriented) or interest rate risk (if defensive).

While the benefits of spreading risk across more asset classes and strategies were limited through the worst of 2008, this doesn’t negate the long-term case for diversification.

Alternative investments are an important part of this proper diversification and, as mentioned above, some alternatives met expectations last year.

Having said that, there are valid concerns with some alternative investments. Some failed structurally, especially from a liquidity perspective. Some fees are too high relative to the value added. Identifying skill in the area is challenging.

The outcomes of 2008 therefore provide grounds to rethink the best way to get alternative investments exposure in portfolios, but it should not provide the basis to blindly reject them all in the quest for simplicity.

Often it is the more complex areas, those that are more difficult to analyse, where the best values and opportunities lie, particularly given the strong rally we have seen in traditional markets.

Markets are no longer undervalued and investors will need to look beyond the simple and conventional for better returns.

For example, illiquid investments are being shunned in the quest for simplicity. But some exposure to less liquid investments can still make sense if a reasonable illiquidity premium is being earned.

There is, however, the problem of how one gets exposure to these areas in a world obsessed with daily liquidity.

Listed investments companies (LICs) is an area where there are periodically some exceptional opportunities to buy portfolios of assets at significant discounts to net asset value, where both the outlook for the assets and a narrowing discount can significantly boost returns.

However, most of these are off the radar of many investors who are building and managing simple portfolios.

In addition, some of the better boutique and specialist managers have become neglected in the current environment.

However, given their small size and flexibility, some of these are best positioned to produce good returns in coming years.

Some investors are retreating to the comfort of large brand names and well-known investments. But some of these large, brand name managers are likely to be mediocre performers given the constraint of large assets under management.

Arguably, these simple portfolios are more vulnerable to the next decline given the greater focus on mainstream, long only exposures and the risk of these becoming overvalued as they are heavily pursued by investors generally.

Crowded spaces are not conducive to good returns and low risks. For example, an emphasis on passive index approaches can lead to biases towards those areas that have already performed well and are overvalued and vulnerable.

Some investors seem to be taking the simplistic view that we are now in a new bull market and simple, long only portfolios are certain to deliver strong returns.

This is one scenario, but I can think of two or three equally likely ones where such portfolios will disappoint.

Clearly, a big beneficiary of the move to simplicity has been the swing to passive funds. Index funds and passive approaches such as those used by DFA are dominating fund flows.

But is now the time to have a large part of an investment portfolio in passive investments?

I am not against the use of passive investments. Indeed, we use passive components at times and for a range of purposes, both long and short term (including for asset allocation flexibility).

Indeed, I can totally understand (although disagree with) those who have taken a philosophical stand to only use passive investments but also do a good job educating their clients about the implications of this and the long-term nature of market risks and returns.

More concerning, however, are those advisers who have knee-jerked into using a lot more passive investments recently in response to events without that same philosophical conversion and the provision of detailed explanations to clients.

How will these advisers respond to clients when the inevitable periods of poor passive versus active performance arrives?

To blindly go passive for simplicity reasons now could create even more problems down the track.

Given some of these possible problems/limitations of simple portfolios, what is the driving motivation to provide them?

Frustration and disappointment in a whole range of investment products and the investment industry generally appears to be one, and this is understandable.

Many investors or their advisers are also embarrassed by what they have ended up holding in portfolios. We have all made some investing mistakes that in hindsight we would have preferred not to have made.

However, just because it was a mistake to buy something historically does not necessarily mean that the right thing to do is sell it now.

It is such emotional responses that result in poor returns and higher risks for clients. Advisers and investors are attracted to those investments that look good (ie, those that have performed well historically).

Typically, however, these are often overpriced and vulnerable to poorer returns looking forward.

The quest for good looking portfolios that make investors and their advisers comfortable is therefore a recipe for poor results.

Good active investing is frequently very uncomfortable.

It involves going against conventional wisdom, contrary thinking, holding onto or adding to poorly performing funds or investments areas and reducing exposure to those that investors are clamouring for.

Managing all this well is clearly complex.

Many in the industry just don’t seem to get the practicalities of managing investment portfolios in the real world.

They think they can totally revamp their approach to building portfolios every couple of years (normally in reaction to recent financial events) without such restructuring badly impacting the long-term returns of their clients.

While entering and exiting investments is itself costly, the most costly part is that they are normally selling out of the things that have not worked recently and buying the things that have produced good recent returns.

This is a recipe for poor long-term results.

There is also the issue that many investors are locked into investments that they cannot get out of even it they want to.

In the real world you simply can’t start with a totally clean sheet of paper on a whim whenever the wind changes.

While one needs to be prepared to change one’s approach when there are fundamental changes in markets or the structural/regulatory environment, this is actually quite rare, and in any case usually gradual.

Further, any such change should be for fundamental investment rather than marketing reasons (ie, not just because the new approach is easier to sell).

When investing becomes too easy and comfortable, you are probably doing the wrong thing and setting up for a fall.

Active value and contrarian investing works well in the long term, and it works mainly because many investors don’t have the stomach to handle the self doubt, derision and even disgust that a value approach can involve. Instead, they go for the simple good looking portfolio — the placebo.

Well-structured portfolios should be in a position to consider and use complex investments and a robust investment portfolio can often look complex itself.

The key issue is where the complexity lies and who is responsible for it. Some planners should be outsourcing decisions in this area to people they can trust rather than just saying they won’t invest their clients in certain areas because they don’t understand it.

Having said this, there is no perfect recipe for building portfolios.

Simplicity may be the fashion today (and it is easy to see why), but good investing has never been about following fashion. Indeed, it is about the opposite.

The events of the last couple of years should encourage deeper assessment and a rethink of various investing strategies and investments areas.

But rethink is the key.

Not an abandonment of sound approaches or a dumbing down of portfolios that results in less diversification, higher risks and, ultimately, poorer returns.

Simplicity or complexity — neither make sense for their own sake — the key is what is actually being done rather than attaching labels to it. Good investing is sometimes simple and sometimes complex — let’s just accept this and get on with doing a better job for clients.

Simple portfolios may make investors feel good at the time they are put in place. But are we just giving investors a placebo?

Such portfolios may well fail to deliver or meet investor expectations because too often they are being put together by looking in the rear-view mirror.

In today’s complex world, that is a very dangerous approach.

At the very least, those going down the simple route need to point out the risks of such an approach — poor diversification, missed opportunities and potentially poor returns if the next 10 years turn out differently from recent decades.

There is also the possibility that clients of advisers who position themselves as investment specialists, but then recommend simple portfolios only, will start to question the value add from that adviser.

In the words of Albert Einstein, things should be made “as simple as possible but no simpler”.

It seems that some advisers may be already pushing through that ‘no simpler’ boundary. In doing so, they ultimately risk making things too simple for their clients’ investment requirements and inadvertently putting their own business model at risk.

Dominic McCormick is chief investment officer at Select Asset Management.