End-of-year recaps have highlighted the remarkable market advance that occurred despite any number of troubling economic and fiscal events in 2013. US stocks led the way–the S&P 500 closed out 2013 with its best year since 1997 (+32%). It hit a new all-time high on the last day of the year, bringing the total gain since March 9, 2009 to 173%.1 Investors in broadly diversified portfolios of equity and fixed income assets are gratified to have recovered their bear market losses and more.
While the gain last year was outsize, it is not surprising to us that investors would be rewarded by remaining invested (in fact, rebalancing into equities) after the crash.
From our perspective, the basics of investing are pretty simple—choose an asset allocation that is designed to meet your long-term objectives for risk and return, invest in a low-cost, globally diversified portfolio that is managed for taxes, and stay disciplined by rebalancing after significant market movements.
That approach is looking better and better these days, but is still not an easy one for many people to digest. Many are sold on the idea that in order to be successful, an investment strategy has to be complicated. After all, isn’t all the smart money using all sorts of vehicles and structures not available to the average man or woman on the street and beating the rest of us as a result?
Follow the Smart Money?
Well, we’ve seen some interesting five-year results from what are frequently considered the most sophisticated investors around—university endowments. Endowments have typically had large allocations to alternative investments, such as access to hedge and private equity funds not available to smaller investors. The recent results?
For the five years ended June 30, 2013 (fiscal year end for endowments), the median return in Callan Associates’ Endowment database was 4.56%. A simple 60% S&P 500/40% Barclays Aggregate portfolio returned 6.95% over the same period. (Not to be accused of cherry picking given the strong 5-year outperformance of domestic over international stocks, even using global equity in the 60/40 mix produces a 5.32% return, substantially better than the endowment median.)2
Not so good for the endowments. But what about the elite universities, where the highest paid talent resides? Recruitment firm Charles Skorina & Company looked at the results for the Ivy League plus four other schools over the same period.3
Harvard, with the largest endowment and the highest paid investment chief, had an abysmal 1.7% return. After noting the conspicuous absence of 5-year returns from an endowment performance letter, a Fortune article mentioned potential reasons for the severe underperformance—the endowment’s size, the low allocation to public equity, and the forced selling of illiquid alternative investments coming out of the crisis.4
Alternatives usually come with added issues of illiquidity, lack of transparency and high fees, all of which can combine to reduce returns.
That is not to say there is no place for alternatives. They may be appropriate for large investors who could benefit from the diversification, return enhancement and/or volatility reduction they can provide on top of a portfolio of traditional assets. Investors who enter the alternatives arena with their eyes wide open to the potential issues noted above can structure a portfolio appropriately, taking cost, complexity and liquidity into account.
So maybe the smart money isn’t so smart, and complexity doesn’t mean sophistication, at least over the recent past. We talk to people every day who are still looking for the secret sauce to beat the market on the upside while avoiding the downside. Wall Street has done its best to create and promote products that purport to do just that and then to convince people they need them. The more complicated and difficult the product is to understand—the better to justify those high fees.
Back to KISS
My colleague on the Hewins Investment Committee, John Bussel, wrote about this three years ago, specifically with respect to structured products, those complex, financially-engineered instruments that proliferated after the crash. Not a lot has changed since then. We frequently look at portfolios of structured products that new clients bring as legacies from a previous broker. It takes some digging to sort through the complicated terms of these securities, but most are tied to equity indices with a common theme of capping the upside that has to be paid to the investor. It is hard to think about how these were explained to clients by the broker who sold them, and to think about the money given up in a strong bull market by those choices.
In his excellent book on the financial crisis, After the Music Stopped: The Financial Crisis, the Response, and The Work Ahead, Princeton economist and former Fed Vice Chairman Alan Blinder identifies Complexity Run Amok as Villain #5 in the crisis. While the complex financial engineering he’s talking about relates to mortgage securities, the principle is the same:
“Why create such a complex system? …The answer is, in fact, simple, and not at all stupid: Complexity and opacity are potential sources of huge profit. The more complex and customized the security, the harder it is to comparison shop for the best price.”5
In Blinder’s Ten Financial Commandments for moving forward out of the crisis, #6 is Thou Shalt Keep It Simple, Stupid:
“Modern finance thrives on complexity; indeed, you might say that the central idea of financial engineering is complexity. Ask yourself whether all those fancy financial instruments actually do the economy any good. Or are they perhaps designed to enrich their designers?”6
That is good advice for anyone considering or being pitched investments that are hard to understand. Our preferred approach is to take advantage of the long-term returns available in the public markets in a diversified, low-cost, tax-efficient manner that is transparent. While we won’t try to convince anyone that over shorter periods there is no downside associated with this approach, the past five years have been solid evidence of the long-term returns the markets have to offer. If more investors had obeyed the Thou Shalt Keep It Simple, Stupid commandment, they too might have more fully participated in this extraordinary recovery.