Complexity adds to cost and risk

One of the biggest attractions of a passive investment strategy is the simplicity of it.

You don’t have to speculate on particular sectors or regions, or constantly monitor how your portfolio is performing. The long-term market return is more than adequate to meet the need of most investors.

Capture that return at very low cost and you’ve got every chance of success.

Index funds themselves are simple, and you know exactly what you’re getting with them. But when you buy an actively managed fund you can never be quite sure.

For example, many active equity funds include an element of bonds, cash or both and active managers typically turn over their entire portfolio every couple of years or so.

So it’s very difficult to keep tabs on how your funds are actually invested at any given time.

A more worrying development in recent years is that active managers are finding it increasingly hard to beat their benchmarks. They’re then resorting more and more to complex strategies. These tend to come in one of the following forms:

Leverage — in other words, the fund manager borrows money to increase the potential return of an investment.

Short selling — where the manager sells a security that they don’t own, or that they have borrowed, in the hope that the security’s price will decline. They’ll then buy it back at a lower price to make a profit.

Options —the fund manager pays for the right to buy or sell a security at an agreed price at a later date.

They’re often called hedging strategies; that is, they’re supposedly designed to protect investors from risk. In practice, though, they often have the opposite effect. All three types of strategy carry a degree of risk that the investor may not want to take.

New research from Canada has confirmed that active managers are making increasing use of these complex strategies, resulting in higher fees, lower returns and greater risk. The paper, entitled Use of Leverage, Short Sales and Options by Mutual Funds, was produced by three academics at the Smith School of Business at Queen’s University in Ontario.

According to the authors — Paul Calluzzo, Fabio Moneta and Selim Topaloglu — in the 15 years prior to the paper’s publication in March 2017, 42.5% of US domestic stock funds have used leverage, short sales or options at least once. Between 1999 and 2015, the percentage of funds allowed to use all three rose from 25.7% to 62.6%.

But the researchers found investors were paying the price for this additional complexity. They calculated that funds that used complex investments, had a 0.59% decrease in excess return and a 0.072% increase in expenses.

So, what did the researchers find specifically at risk? To quote the paper: “Although (managers) use the instruments in a manner that decreases the fund’s systematic risk (i.e. the risk of something impacting upon the overall market), they hold portfolios of riskier stocks that offset the insurance capabilities of the complex instruments.

They also found that funds which use complex instruments take more risk, both in terms of market risk and individual company risk, in how they approach investing in equities.

“Overall, it appears that mutual fund investors are better off choosing simplicity.”