Our tenure in the investment business has made us keenly aware of a profound investor bias toward complexity. In this article, we examine the reasons for the bias, which we believe are behavioral in nature. One reason is the rationalization by asset managers that to charge higher fees requires offering more complex strategies. A similar line of reasoning may also influence those who recommend managers: consultants and advisors. A second reason for the bias is the rationalization by investors that a complicated strategy is necessary to beat the market. Each explanation has implications—biased toward the negative—for an investor’s long-term performance.
Complexity Can Confound Performance
In contrast to the overwhelming pressure from all sides in advancing complexity, our experience, as well as our research and that of others, supports the virtues of a simple approach. For example, in 2009, DeMiguel, Garlappi, and Uppal demonstrated that numerically optimized portfolios using various expected return models generally perform no better than a simple equal-weighted approach.
An example of our research in this area, the article “A Survey of Alternative Equity Index Strategies” by Chow et al. (2011), is an analysis of the most popular smart beta strategies. We found that simple, low-turnover and complex, high-turnover strategies all work roughly the same on a gross-of-fee basis, suggesting on a net-of-fee basis the simple, low-turnover strategies might have an advantage.
Looking beyond the story telling that characterizes various investment philosophies, the long-term return drivers of many complex smart beta strategies are tilts toward well-known factor/style exposures, such as value, size, and low volatility. Each exposure is a natural outcome of breaking the link between portfolio weighting and price, and of the requisite rebalancing. Indeed, little data or research supports one “best” way to construct an exposure (e.g., value or low volatility) that maximizes the factor premium capture. Complex constructions in the historical backtest appear to mostly guarantee higher turnover, higher management fees, and potentially worse out-of-sample returns.
So, if complexity doesn’t naturally lead to outperformance, why do asset managers persist in offering increasingly complicated strategies to investors, and why do investors persist on investing in them? Allow John to tell an illustrative parable.
John’s Fish Tale
The oceans in which fish hide from fisherman are amazingly complex ecosystems. The circumstances leading to a successful day (or not) on the water are almost innumerable. The fish obviously have to be at the fishing spot. But that’s probably less than half the battle. A veritable mosaic of tides, currents, sunlight, moonlight the night before, available prey, time of day, tackle, and so on, influence the catch. With such a myriad of factors, it’s no small wonder that tens of thousands of fishing products jam their way into even the smallest of tackle shops.
But, as an avid deep sea angler, I can attest to catching twice as many tuna with the simplest of lures than all of the rest combined. The lure? The innocuous-looking cedar plug pictured in Exhibit A. Simple? Yes! For crying out loud, it’s a piece of lead attached to an unpainted piece of wood with one lousy hook! It looks like an industrial part. Sexy and complex? Most certainly not.