In complex world, investing should be simple

LARRY SWEDROE / 

MONEYWATCH/ May 21, 2013, 7:00 AM

In complex world, investing should be simple

(MoneyWatch) Many investors have ventured into the land of alternative investments, including such alternatives as REITs, commodities, private equity and hedge funds. However, a recent paper by the chief investment officer of a pension system says these investors may want to think twice.

Robert Maynard, chief investment officer of the Public Employee Retirement System of Idaho and author of the article “Conventional Investing in a Complex World” (Journal of Investing, Spring 2013), cautions investors who are thinking about abandoning traditional investment plans. He advocates “policies that are simple, transparent, and focused rather than the increasingly popular alternative tactics, such as illiquid instruments and vehicles, leverage, and complex, opaque investment strategies.”

As we have shown here on a regular basis, hedge funds have had a hard time keeping up with the risk-adjusted returns on safe bond investments (let alone with the returns of publicly available stocks). And private equity has underperformed publicly available small value stocks. This is in addition to the greater risks of such investments, plus their lack of transparency and liquidity.The good news for individual investors is that they can achieve effective diversification across multiple sources of returns without having to venture into alternatives. Moreover, competition and innovation have driven down the costs for the publicly available investments that can be used to diversify portfolios. Individual investors can build a globally diversified stock portfolio, with allocations to U.S., developed and emerging-markets stocks, and tailor their portfolio to their own preferences for exposures to large, small, value and growth shares. And there are now a wide variety of index and other passively managed funds that allow investors to access stock strategies that the most sophisticated institutional investors utilize (such as incorporating momentum and tax management), and their costs are way below that of hedge funds and venture capital firms. Similarly, passively managed bond funds are also available that allow investors to diversify across real and nominal bonds as well as short-term, intermediate-term and long-term bonds.

Individuals can also diversify their portfolios by adding exposures to REITs and commodities using low-cost, passively managed vehicles. They can even access what is called the carry trade (another source of returns) through investments in relatively low-cost and passive vehicles.

The bottom line is that while diversification of risks is the central tenet of prudent portfolio construction, investors can obtain all the diversification they need through publicly available vehicles. They don’t need the complexity or the high expenses of actively managed, private alternative investments to build highly diversified portfolios. By investing in publicly available funds, they maintain total transparency and have daily liquidity. This is important because the benefits of diversification are greatest when you can rebalance, which can be done only if you have liquidity.

In addition, using passively managed vehicles avoids the risks of unexpected actions and concentrated (undiversified) positions taken by active managers. The results delivered since the great financial crisis demonstrate this point very clearly. Investors who relied on hedge funds and private equity to reduce their risks generally weren’t rewarded for their beliefs. And even well-regarded institutions learned a lesson about their ability to take liquidity risk — a risk inherent in many alternative strategies. As Maynard noted in his article: “Institutions like Harvard, Princeton, and Stanford had to issue billions in new bonds simply to meet short-term cash obligations. Liquid instruments, like public equities, had to be sold at rock-bottom prices to meet other obligations. With the rest of the portfolio frozen, the portfolios of funds that had followed the endowment model could not rebalance, and generally missed the stunning rebound of the capital markets in the second quarter of 2009. The liquidity problems of the endowment model have been well-demonstrated.”