There is a gravitational pull toward complexity in the investment ecosystem. Among the forces continually pushing it to be ever more complicated are the relentless quest of analytical inquiry, the appeal of elaborate explanations that project sophistication, and the interests of the industry’s chain of agents, who are compensated for creating and marketing new products and services.
Investment organizations of every type have to deal with issues of complexity. Identifying where it exists is a necessary part of organizational strategy. In this posting, we’ll review a few of the elements an investment advisory firm should consider along those lines; many of them translate easily to other kinds of organizations.
For starters there is the reality of human behavior, the bedrock of organizational complexity. While not a focus here, it should not be overlooked. As one example, think of the intricacies of the advisor-client relationship and the ways it can go wrong, with the actions of one or another of the parties (and perhaps both) triggering a schism between them. While advisor training and client education can lessen the probability of such a split, there is an inherent unpredictability involved.
Investment strategies and instruments
Despite the general tendency toward complexity, relatively simple strategies have become more popular over the last few decades, thanks in large part to the inability of active managers as a class to outperform their benchmarks. That performance shortfall is easiest to spot when judging traditional long-only products, where the comparisons are most obvious. In response, asset flows for them have suffered.
At the same time, demand has increased in the opposite direction, for more complex vehicles. In part, that can be chalked up to a greater difficulty in assessing their performance; among the issues across various products are the lack of clear benchmarks, the use of different performance metrics and standards, lags in the reporting of results, and the lack of independent verification of the valuations used to calculate those results. The absence of comparability has led to the belief that the strategies and managers of alternative investments can add value when more mainstream ones cannot.
As one example, take structured products. Often presented to clients in superficially simple ways, they leverage “derivatives magic” (to steal a phrase from Matt Levine) to deliver nice profits for the firms that manufacture the products and fat incentives for the advisors who place them, but hard-to-decipher results for the investors to whom they are sold.
In a recent review of research on structured products, Larry Swedroe called them “financial fairy tales,” complete with “shiny features designed to entice naïve investors.” Yet, an RIA Intel article, “Is Now the Time for Structured Notes?” cites a Cerulli report that predicts further growth because they “can provide unique terms better suited to specific client situations.” (And the growth won’t just be coming from broker channels, since newer products “can be easily slotted into fee-based accounts.”)
Private equity exposure is also growing quickly at advisory firms. That is likely to continue, since private equity managers have identified individuals (including their defined contribution plans) as the next avenue of growth — and clients have been pestering advisory firms to give them access to PE funds. Advocates promote the benefits of diversification (although that is mostly illusory, driven by lags in pricing) and historically strong returns (although the conditions today are much different than those in years past).
In 2022, Don Phillips of Morningstar wrote a column in which he identified “The Four Horsemen of Investing”:
Complexity, concentration, leverage, and illiquidity are the four horsemen of the investor apocalypse, perennial threats that wreak havoc on portfolios and undermine even the best-laid plans of diligent investors and their advisors.
How do you analyze those threats?
A framework for evaluation
One method comes from a 2015 Financial Analysts Journal piece, “A Risk- and Complexity-Rating Framework for Investment Products.” It uses the positioning of a few examples (including structured products) to illustrate how the range of possibilities could be mapped:
The complexity rating uses five factors:
And a very simple grading approach:
A similar process results in a risk rating, allowing the completion of the two-by-two grid. You may disagree with the placements of some of the examples on that grid, or you may think that the approach is rudimentary. The point is that having a framework of some kind allows for a degree of specificity that can feed into your decision making process.
Due diligence
Many advisory firms are understaffed and undertrained when it comes to due diligence, forcing them to rely too heavily on information from the managers of products and from third-party research providers. Any shortcomings along those lines are exacerbated when investing in new and complex areas. There is an increased burden that comes from evaluating more complex investments because of the need to understand unfamiliar strategies and managers. Underestimating those demands in a rush to offer new exposures to clients is likely to prove costly over time.
Communication
Talking about complex ideas with a client should always be based upon their individual knowledge and readiness. Therefore, the discussion of an investment or strategy or plan requires an ability to adapt to the specific communication circumstances at hand, rather than relying on standardized explanations and materials to convey a particular message. In reality, most investment-speak is counterproductive, charts and graphs that seem obvious to a practitioner can be unintelligible to a lay person, and it is challenging to simplify an investment recommendation and still convey the risks and range of possibilities inherent in it.
With complex investments, all of those issues are magnified.
In a piece on the tradeoff between liquidity and illiquidity, Phil Huber used the example of the Blackstone Real Estate Income Trust (BREIT) to illustrate an important principle. He observed that Blackstone followed the liquidity terms in the fund documents when it gated withdrawals from BREIT, so it should not have come as a surprise to investors. But:
What is less clear is how many of the individual investors in BREIT had the liquidity terms clearly laid out to them when the fund was presented by the advisor pitching it to them. For some investors, it is highly likely that important details were glossed over or left out altogether. It is exactly these gaps in communication and mismatches in expectations that can transform a feature into a bug in the blink of an eye.
That last sentence — “It is exactly these gaps in communication and mismatches in expectations that can transform a feature into a bug in the blink of an eye.” — is a powerful reminder for advisors of a foundational principle that is easy to violate.
Other issues
One of the biggest challenges for advisory firms is operational complexity. From a business model standpoint, it is desirable to make everything routine, but meeting the individual needs of clients makes that a pipe dream. Striking a balance between those two goals is a never-ending endeavor.
Technology is another puzzle. A wide range of capabilities is needed to run an advisory firm and it seems that there are always shortcomings to be addressed. Systems developed internally are usually Excel-based and prone to problems, but off-the-shelf solutions may not adequately meet the identified needs — and hiring a firm to do customized development can be very expensive and time-consuming. No matter the chosen path there are conversion headaches during the process — and new strategies and vehicles will eventually render the final product inadequate in some way. The hoped-for systems sweet spot is ever elusive.
There have been a number of regulatory changes affecting advisors in the last few years, so compliance concerns are compounding and examinations will be more expansive than they have been in the past. More and more complexity being built in.
As is the case with due diligence and communication, the introduction of new investment vehicles adds layers of complexity to operations, systems, and compliance, so there is a ripple effect for the organization, with surprises occurring beyond those anticipated on the investment front.
For an unlikely example, consider ESG investing. It was pretty smooth sailing for quite a while. Assets were growing, performance was good, and clients who were looking to find investments that fit with their beliefs could do so via an expanding selection of offerings. Now ESG is a political football and advisors can be caught in the middle of the battle. Plus, there is an increasing realization that there is more to the analysis of an ESG vehicle than meets the eye. While not quite greenwashing, putting clients into ESG investments without an understanding of the intricacies of industry rating systems and manager processes (or the systems to properly track them) raises some fiduciary questions.
Under any circumstances, market stress can amplify organizational stress and business model stress. Increased complexity of whatever sort means that periods of pressure can be more unpredictable than they otherwise would be. In all respects it pays to gauge the payoff for complexity and the potential downsides involved, so a multidimensional analysis of it should be part of your strategic planning process.
Published: September 9, 2023
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