Don't Fear The Complex, Don't Abuse It Either

Morningstar had an article titled Why Investment Complexity Is Not Your Friend. With the priority we place on relative simplicity here, this of course was of interest to me.  The intro talked about the proliferation of new funds that are not plain vanilla, the types of funds we explore here frequently. Morningstar noted that with the new funds, the "range of options (can) be overwhelming, but it often leads to worse investor outcomes."

Agree with me or disagree but there is utility in these funds which Morningstar does not seem to believe but it is very easy to use them incorrectly leading to bad outcomes, on this point I agree with them. There are a couple of niches that seem to have gotten more attention on Twitter and blogs including here; managed futures and capital efficient funds that use leverage to build exposure to more than one asset class with the expectation that the blending of those asset classes will lower volatility.

The common argument against these funds goes down the road that no one needs them and even because some people will misuse them they shouldn't be available to investors. 

I don't know whether these funds rise to the level of fad of not but things that are faddish often do end badly. Yes, the funds that are using leverage, I certainly can't say they are misusing leverage, might lead to bad outcomes for investors. The idea of blending two or more assets that usually have negative correlations together, even with leverage is not on its face terribly risk but neither is it infallible. You don't need to spend time isolating what specifically could go wrong, just knowing that something, anything, could go wrong is enough.

A modest allocation to a fund like we're talking about that blows up it little more than a lesson learned with no financial damage done. Repeating from past blog posts, just like 20% into REITs, MLPs or gold was a bad idea when pundits were suggesting that leading up to the Financial Crisis, 20% into managed futures or risk parity or some of the others are a bad idea now. 

Like a lot of things there is a balance to be struck here. First, plenty of investors simply do not believe in using these types of strategic tools. That's valid. Don't use them if you don't believe in them. To Morngingstar's point, they are not simple, they are opposite of simple. The Morningstar article doubted investors' ability to understand these funds. Certainly, not every fund strategy will be clear to you or to me or to anyone else. Anyone considering these funds needs to invest time into understanding the strategy underlying any fund catching their eye. 

While I agree that using just one fund with a 20% weighting to hedge or otherwise protect the portfolio is a nice clean idea that is appealing on some level, I think it is a bad idea. In some random event both your core, like equities, and hedge could both go down at the same time. Managed futures usually centers around a 10 month trend. A few weeks ago most of the space got caught wrong footed when yields on short term treasuries dropped dramatically. There is no reason why managed futures couldn't get wrong footed again at the same time that equities are going down. This could be the case with any of the hedge/protection funds we talk about. Once you figure out how much you want to own, less than 20% for me, I would suggest owning several different strategies in smaller slices rather than one strategy in a big chunk. 

To the title of the Morningstar article, complexity can be your friend when used/sized correctly. We talk all the time about plain vanilla being the thing that goes up the most, most of the time. It doesn't get much simpler than plain vanilla equities. A little bit of complexity as a your hedge, when used correctly can go a long way to managing volatility and as we saw in 2022, can be more effective than fixed income for this purpose. Simplicity hedged with a little complexity.