The fifth risk of investing: Beware of complexity and the costs that come with it – TheChronicleHerald.ca

In our household, the political discussions are vigorous. Trump, Trudeau, deficits and pipelines are regularly in the mix. For me, however, one of the biggest issues facing society today is increasing complexity. How do we cope with the complexity that comes with rapid technological change and unconstrained information flow via social media? And more to the point, how do governments and regulators deal with it?

When it comes to investing, I’ve long felt that complexity should be added to the list of core risks. Traditionally, risk has been put into four buckets: interest rates; credit (or default); equity and liquidity. Each brings with it the possibility of increased volatility and capital loss, but also the potential to earn a return above the risk-free rate. There’s no way around it — you need some combination of the four to do better than the yield on a GIC or government T-bill.

One of the problems with adding complexity to the list is that it’s not as productive as the others. Indeed, if we were charting it, the line would tend to go in the opposite direction — i.e. the more complex, the lower the long-term return.

Of course, I’m generalizing. Like all investment strategies, outcomes can vary widely. For instance, many highly engineered products do just fine (just as most high-risk bonds don’t default and few stocks go to zero) but they carry more baggage than other investments do.

Transparency lost

Complicated fund structures suffer from a lack of transparency. It’s not always clear, even when you read the fine print, what’s driving the return and where the potential risks are. Selling documents often hide behind words like “dynamic hedging” and “risk parity” which sound cool but say nothing about where the risks lie.

With a lack of transparency comes unexpected results. It’s only after a disappointing result that you’re told about the impact of widening credit spreads, increased (or decreased) volatility or other market factors.

This year, Albertans learned this firsthand. AIMCo, the province’s investment management arm, saw its volatility trading strategy blow up, causing a $2-billion loss. It was clear afterwards that management didn’t fully understand the range of possible outcomes.

Too many mouths to feed

A big contributor to lower returns is cost. Every new product feature brings with it more people and bottom lines to feed. Investment bankers, currency and derivative traders, prime brokers, lawyers and salespeople don’t come cheap.

And in many cases, the sponsor takes a healthy slice of the spoils, either through a performance fee or additional shares.

A different goal

In addition to the heavy baggage, however, there’s a good reason why complex investment products offer a lower return. Typically, they’re not trying to maximize return. Rather, they’re seeking to provide a smoother pattern of returns by using diversification, hedges and innovative structuring. These strategies are aimed at reducing the volatility that normally comes with holding corporate bonds and stocks.

Liquid-alt funds, an emerging fund category using alternative strategies, are trying to do just that, as are Canada’s most popular structured products — index-linked notes. These notes are sold in the bank branch and are designed to give holders some stock market exposure with no downside risk. Unfortunately, they too have poor transparency and high fees. The notes are linked to price indexes that don’t include dividends, and the sponsoring banks promote cumulative returns which makes it hard to compare them to other funds and GICs. Needless to say, they’re a healthy contributor to the profitability of multiple bank divisions.

Buyer beware

If you’re being encouraged to buy something you don’t understand, push the pause button and start asking questions. You need to understand who the key decision makers are, where the return will come from, what could cause it to go south, how it complements your other investments, and to what degree your advisor understands it.

There are no bad questions, only bad answers. If you’re told “there are no risks”, “it’s a big seller”, or “trust me”, then keep probing. Complexity brings with it a new set of unknowns and a lot of extra cost.

Tom Bradley is


chair and chief investment officer


at Steadyhand Investment Funds, a company that offers individual investors low-fee investment funds and clear-cut advice. He can be reached at

tbradley@steadyhand.com

.

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