Don't Get Sabotaged By 'Sophisticated' Investing

Eric @ SERVO profile picture
Eric @ SERVO
1.11K Followers

Summary

  • Diversification, understanding risk and return, and keeping fees and taxes to a minimum are fundamental principals for long-term financial success.
  • Some investors cannot avoid over-complicating this simple formula by adding complex "alternative" assets to a traditional stock and bond portfolio.
  • Evidence finds that investors badly misuse alternatives, buying and selling at the wrong time and losing upwards of 2% a year of their gross returns.

The more we learn about investing, the more we appreciate that holding well-diversified portfolios, targeting a few primary sources of expected returns (such as stocks over bonds, small vs. large cap and value vs. growth stocks), and keeping fees and taxes low is the most sensible approach. This should be welcome news for all. Investors don't need complicated investment strategies; a simple and efficient approach should be sufficient to achieve their goals. Advisors no longer have to pretend to be the wizard behind the curtain, knowing all the right levers to pull. Investors are increasing looking to us for a goal-specific financial plan and an efficient investment portfolio that they can understand and follow.

Yet the financial industry continues to develop seemingly sophisticated "alternatives" that claim to enhance the results of "traditional" portfolios of stocks and bonds, both through higher returns and lower risk (because of favorable correlations with other assets). Individual investors have a difficult time avoiding these strategies as they struggle to fully commit to a simpler and more straight-forward approach. Many advisors fall victim as well, unable to wean themselves off of selling complexity marketed as sophistication.

How has this worked out? Not well.

CATEGORY/Fund

2014 to 2016* INVESTMENT Return

2014 to 2016 INVESTOR Return

DIFFERENCE

STOCKS

DFA US Core 1 Fund (MUTF:DFEOX)

+7.77%

+7.69%

-0.08%

DFA US Core 2 Fund (MUTF:DFQTX)

+7.30%

+7.34%

+0.04%

DFA Int'l Core Fund (MUTF:DFIEX)

-0.39%

-0.25%

+0.14%

DFA EM Core Fund (MUTF:DFCEX)

-1.77%

-1.89%

-0.12%

ALTERNATIVES

AQR Diversified Arbitrage Fund (MUTF:ADAIX)

-0.94%

-3.71%

-2.77%

AQR Long/Short Equity Fund (MUTF:QLEIX)

+14.32%

+13.29%

-1.03%

AQR Managed Futures Fund (MUTF:AQMIX)

+0.81%

-1.68%

-2.49%

AQR Multi-Strategy Alternative Fund (MUTF:ASAIX)

+5.38%

+3.98%

-1.40%

AQR Risk-Balanced Commodity Fund (MUTF:ARCIX)

-7.54%

-8.28%

-0.74%

AQR Style Premia Fund (MUTF:MUTF:QSPIX)

+6.41%

+3.63%

-2.78%

*longest available data for some of the Alternative strategies

The chart above first looks at the "INVESTMENT returns" on a handful of broadly-diversified stock portfolios managed by Dimensional Fund Advisors (DFA) over the last 3 years. The mutual funds target US and non-US markets with "tilts" towards smaller and more value-oriented companies. While not technically index funds, these strategies are still cheap, well diversified, tax efficient, and simple to understand. The "INVESTOR returns" measure the actual results that dollars in the funds achieved, after controlling for their timing (when money came in and went out). An investor return that is close to the fund return means that shareholders mostly bought and held, earning the full return of the strategy. The evidence finds that investors have mostly stayed the course over the last 3 years with straightforward stock funds; the average spread between fund returns and investor results has been approximately 0%.

In contrast, the chart also reports a handful of "alternative" strategies managed by the industry leader in this space, Applied Quantitative Research (AQR). There's a lot going on inside these funds -- long and short positions in stocks, bonds, commodities, currencies, momentum, carry, and other fairly sophisticated techniques. I'd have to dust off my CFA text books to fully understand them. A look at the INVESTOR returns compared to the INVESTMENT returns across these alternative strategies reveals a general pattern of bad behavior -- buying and selling at the wrong time. The "behavior gap" (investor return minus investment return) ranged from -0.74% per year to -2.78% per year, and was -1.87% across an average of each strategy.

To be clear, I have the utmost respect for AQR, and for all I know these might be the best strategies in the marketplace, positively complimenting a traditional stock and bond portfolio on paper. But if the average investor or advisor in the funds is losing almost 2% a year through poor timing, even AQR's investment acumen won't be able to overcome that drag.

Staying the course with a portfolio of stocks and bonds is hard enough. If you're tilted to small cap and value companies, you know they can sometimes underperform the market and test even the most hardened investor's resolve. Adding any number of "alternative" strategies to this approach is just asking for trouble. To waste your units of discipline on unconventional strategies whose returns often defy expectations and sometimes don't even pan out is ill-advised. Better to save up the courage for when stocks crater or when one part of the global market goes on a tear, testing your resolve to stay diversified (remember the Tech bubble?). A straightforward stock and bond portfolio is easier to understand, simpler to manage, is more efficient from a tax perspective and keeps costs acceptably low. For all the sophistication behind many of these alternative approaches, the evidence finds they're just providing investors and their advisors enough rope to hang themselves.

_______________________________________

Source of data: morningstar.com

Past performance is not a guarantee of future results. Index performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

This article was written by

Eric @ SERVO profile picture
1.11K Followers
I founded and manage Servo Wealth Management, a Registered Investment Advisor (RIA) firm that helps people achieve financial independence, a secure retirement, and positions them to leave a meaningful financial legacy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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