David Peartree, BridgeTower Media Newswires
In the world of investment products, investors should keep in mind one simple rule: complexity favors the house. The house in this context is the investment company selling the product. Investor, complexity is not your friend.
A recent study looked at the use of complicated investment strategies in mutual funds. The authors examined this question: “Does complex instrument use by mutual funds benefit or harm the fund shareholders?”
Over the past 15 years, the number of funds using hedge fund techniques has increased over a hundredfold. The study looked at three techniques in particular: leverage, short sales and options. Lest you dismiss those techniques as irrelevant to your investment portfolio, consider that more than 40 percent of U.S. stock funds reported using at least one of these techniques and over 60 percent of such funds disclose that they are authorized to use all three techniques.
“Leverage” refers to the ability of a mutual fund to borrow money to fund portfolio purchases. A mutual fund can leverage up to a third of its portfolio value. A “short sale” is the sale of a stock that the fund does not own. A fund might borrow stock from another owner and then sell it on the belief that the stock price will drop. The fund hopes to reacquire the stock at the lower price, return it to its owner and pocket the profit. If, however, the price of the shorted stock goes up, the fund takes a loss. “Options” are financial contracts that place a bet on stock prices moving up or down over a specified time period.
The findings of the 2017 study were not favorable for the investment firms that sell these funds. The authors found that funds using these techniques tend to cost more, produce lower returns and experience higher risk. For investors, those are three key metrics moving in the wrong direction.
Several other findings are worth noting. First, funds tend to start using these more complicated techniques after a period of underperformance and fund outflow, suggesting that they are taking on more risk to “catch up.” Second, compared with funds that don’t use such techniques, funds that do tend to have worse negative outcomes and more of them. Restated, if you were to plot the outcomes of all the funds using these hedging techniques, you would find the graph to be skewed to the left where the negative outcomes are plotted.
Third, and perhaps most interesting, was this finding: “The only setting where the use of complex instruments is not associated with negative shareholder outcomes is when funds use complex instruments in the presence of high levels of institutional ownership.” In plain English, where fund managers have their own stake in the fund — this is known as “eating their own cooking” — they tend to produce better outcomes.
They are, perhaps, more conservative in their use of these strategies when their own money is at stake.
The study’s findings do not mean that hedging strategies are categorically bad or wrong. Used appropriately, they can help to reduce risk. It does appear, though, that their merits in theory and their benefits in practice are not necessarily the same.
The study’s findings suggest some basic principles that investors would do well to remember.
Betting against the market is risky. We know from other studies that betting against the market is, on average, a losing strategy. The investment strategies covered by the 2017 study amount to making bets against the market. Carefully consider whether that is a strategy you want or need to purse, and then consider the fund manager’s track record making such bets.
Other people’s money is different. The way some funds handle “other people’s money” is not necessarily the same way they’d handle their own money, fiduciary duty or not. Do you want to invest with a manager who doesn’t eat his or her own cooking?
Know what you own. A fund’s ability and its proclivity to use more complicated investment strategies may not be obvious but it will be disclosed in several places: the prospectus, the statement of additional information and the annual report. The information is hidden in plain view.
More complexity means higher costs. Unless proven otherwise, assume that complexity is your enemy as an investor. The more complicated an investment product is, the more it tends to cost, and the higher the cost the greater the likelihood that investment performance will disappoint.
Needless complexity should raise your suspicions as an investor, because it stacks the odds against you.
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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice. Offices are located at 160 Linden Oaks, Rochester, NY 14625, david@worthconsidering.com.
