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The Second Opinion #3: Portfolio Complexity
Avoid investments you don’t understand
Why this is important: Making a purchase without understanding the nature of the investment can lead to unforeseen risks.
Most investors use some form of “structured” products, such as mutual funds, income trusts, hedge funds, or exchange traded funds, in their portfolios. Individual stocks and bonds now make up only a small part of the investment opportunities available to investors.
Just as cars and computers have been vastly improved over recent decades, we now have many better, safer, and more complicated investment options. Yet, for every new product that offers the potential for a greater return with less risk, a copycat product is also available. It seems to have many of the best features but has hidden fees and unexplained risks.
Mark Twain, in his short story “The $30,000 Bequest,” was of the opinion that the best way to make money from stocks is to sell investment advice. That opinion could be updated today to say that the best way to make money in the investing world is to create and sell new investment products. Today some of the brightest minds are busy creating new investment products or taking old investing ideas and updating them to take advantage of new technology and new global investing opportunities.
Most investors are busy people. They don’t have the time to study stocks and bonds or the intricacies of the markets. Not to mention understanding income trusts, covered call programs, hedge funds, and structured notes with capital guarantees. Financial advisors themselves often struggle to grasp the complexities and risks of these new structured products. If we have a major downturn, a lot of advisors are likely to be shocked to discover how these often misunderstood risks actually manifest themselves.
For example, look back to the l980s when portfolio insurance was in vogue. This strategy was expected to protect clients in a falling stock market. When the crash came in 1987, we discovered that portfolio insurance, while great in theory, just did not work when the market went into free fall and everyone tried to cash in on the “insurance.”
For the next twenty years, portfolio insurance was seldom mentioned and the strategy was not widely recommended. In 2003, however, I became aware of another “new” product based on the same investing principle, only this time it was not called “portfolio insurance.” This time it was simply referred to as a leveraging and de-leveraging strategy.
It has always been a sensible strategy to avoid investing in things you don’t understand. However, if you want to follow this rule, and you also want to enjoy good investment returns, you have to study some very complex investment products. For example, if you really want to understand hedge funds and certain “structured” investment products, it is going to take a serious commitment. Very few in the investment industry are specialists in hedge funds or even understand them. Knowledge has its rewards, however, and some of the more complicated investment strategies may offer higher returns without significantly higher risk.
Not everybody can be an expert. If you insist on a full understanding of every underlying strategy in, for example, a “fund of hedge funds,” it is unlikely that you will ever buy this type of investment. This may be unfortunate because some of these investments have a history of providing an excellent return for the risk taken.
If you want to enjoy the benefits of many different types of structured products, such as hedge funds, you will probably have to rely on someone else’s expertise. In these cases it may be that the best use of your time is to evaluate the expertise of your advisor and form an opinion as to whether she really understands the products being recommended. You should be aware of the advisor’s experience, qualifications, and reputation. For example, if you are considering hedge funds, check out whether your advisor has acquired a Certified Hedge Fund Specialist (CHFS) or Chartered Alternative Investment Analyst (CAIA) designation.
If you are doing your own due diligence on an investment instrument, you should do the following:
- Look for proven track records. Understand that there is a difference between a real track record and a pro forma track record. The latter is simply a hypothetical record or a reconstruction of how the investment would have performed if it had been available in the past.
- Find out all the costs. Including the hidden ones.
- Don’t put too much in one basket even if it seems very safe.
- Remember that, all things being equal, a solid guarantee from a major bank is a good thing.
- Don’t be in a rush. If it is a good product, wait a few months and the people who created it will create another product.
When in doubt, stick with the structured products of firms that have been in business for decades and have billions of dollars under management. These firms might not put up the huge rate of return numbers that a small firm can generate over a short time, but these firms will likely have more experience, more risk controls, and a stronger guarantee.
Bottom line: You have a tough choice. You can limit your investments to what you currently know or you can take the time to study new “structured” products such as hedge funds. Or, you can make certain that your financial advisor is sufficiently experienced and well enough qualified that you can safely accept his recommendations.
What you can do now: Because you don’t want to miss out on excellent investment opportunities, you have to make a realistic assessment of your financial advisor’s level of knowledge of new investment products.
Ken Hawkins
“Perfection is achieved, not when there is nothing more to add, but when there is nothing left to take away”
Antoine de Saint-Exupery
Introduction
A well diversified and uncomplicated portfolio is almost always better than one that is overly diversified and too complex. This is especially true for individual investors with limited time, analytical tools and expertise. Despite this, many investors find themselves with portfolios that are too complicated to understand, hard to manage, and difficult to make changes with confidence. This is especially true for investors that hold too many mutual funds and invest in too many complex structured products.
Investors do not intentionally develop complicated and cluttered investment portfolios. Reasons that lead to it include a lack of basic understanding of the rules of portfolio diversification, a tendency to buy individual stocks or mutual funds on their own merits without regard to the impact on the overall portfolio, buying investment products that are complex in themselves, and finally, no disciplined investment strategy. After a time the portfolio becomes unwieldy, the risks are not understood, the portfolio becomes difficult to manage, and performance suffers.
Steps to simplify your investment portfolio
Streamlining and simplifying your portfolio will make it easier to manage, ensure it will be properly diversified, and there will be an improved understanding of the risks. In the end this should also improve its performance.
One of the first steps to simplifying your portfolio is to consolidate as many of the investment accounts as feasible. The fewer accounts the better. Allocating investments to the proper accounts can not only improve the simplicity but will also make the portfolio more tax efficient. Although it is important to have an overall objective and asset mix for the consolidated portfolio, it is not important that each account have the same objectives or asset mix. As an example, if the overall portfolio is balanced with 60% equity and 40% fixed income, it is not necessary that every account should have that mix. Each account, whether it is a tax deferred or a taxable account, can have a very specific objective and type of investment. One account might be mostly fixed income and another might be more trading orientated and another for global investing. Consolidating this will not only make it easier to understand and monitor but it might help make them more tax efficient as well. Remember, it is not just asset allocation that you should be concerned with - but asset location as well.
An easy way of simplifying a portfolio is to reduce the number of positions, whether they are mutual funds or individual securities. Small insignificant holdings that will have very little impact on the overall portfolio should be sold. Individual stocks that represent less than 2% of the total equity allocation can often be eliminated without impacting performance or diversification. While broad based mutual funds with less than 5% of the portfolio’s overall market value should be eliminated, specialized mutual funds representing small sub-asset classes might hold less than 5%. Holding balanced mutual funds in a portfolio that is already balanced makes little sense and only complicates matters. Holding mutual funds that only invest in a single asset class accomplishes two things: it makes a portfolio easier to understand at a glance and it will be easier to hold assets in the proper accounts.
An account with many mutual funds will likely include funds that are very similar in style and performance. Eliminating some of the funds and putting the proceeds in the best of the existing funds will simplify the portfolio and improve the probability of outperforming without hurting diversification.
A portfolio containing index funds or some broadly based exchange traded funds is always simpler than actively managed mutual funds or an actively managed portfolio of individual securities. Here investors do not have to be concerned with the active management of the assets – they only need to be concerned about the asset mix. Replacing 3 or 4 mutual funds that invest in Canadian stocks with an appropriate exchange traded fund will not only simplify the portfolio but will probably improve the underlying performance as well.
Conclusion
In investing, as it is in other parts of life, it is often better to keep things simple rather than complex. Simplifying your portfolio will make it easier to understand and mange and in the long run will improve its overall performance. A simpler, less complicated portfolio will allow the investor to focus his effort on improving its performance rather than trying to understand it.