In Search of Simplicity: Part 2

man think how to solve the problem

Topic: Investments

John C.A. Stevenson CFA

February 28, 2018

Image used with permission: iStock/francescoch


Print & Share

Print

In Search of Simplicity: Part 2

In August 2016, my colleague Alex Jemetz wrote a great blog, and published a related white paper, titled, “In Search of Simplicity.” In it Alex highlighted a fairly remarkable fact.

She reveals that, over the period December 31, 1999 to July 31, 2016, the Nexus Balanced Fund outperformed a Global Hedge Fund Index as well as several institutional benchmarks, including one containing lots of exposure to sexy alternative asset classes like private equity and infrastructure. Moreover, the Balanced Fund achieved higher returns at the same time it had less volatility. The point of the comparison was not so much to highlight Nexus’s success as it was to champion our disciplined and straight-forward investment approach. Complexity does not often add value.

This past weekend marked one of the key annual events in the investment calendar – the release of Warren Buffett’s annual letter to shareholders. There are few who would dispute the assertion that Buffett is the greatest investor living today, and his annual letters are filled with both profound insights and amusing witticisms.

A significant portion of his letter this year was devoted to a discussion of the famous wager Buffett made with Protégé Partners 10 years ago. Buffett bet that a very low cost investment in an S&P 500 Index fund would outperform an elite group of hedge funds over a ten year period ending in 2017. Protégé selected five funds-of-funds, which, in turn, had access to the very best hedge fund managers in America. In fact, behind the five funds-of-funds were more than 200 hedge funds. The result was not going to be the case of good luck or bad, but a real measure of whether these high octane investors could do better over a long period of time than the simplest of investment approaches. Moreover, the hedge funds had all sorts of advantages. The funds-of-funds could add or subtract managers from the group to jettison any underperforming manager or to hitch its wagon to someone new doing well. And the incentives ought to have been powerful. On average, the hedge funds received a fee of 2.5% of the assets PLUS a varying share of the profits.

The result… not even close. The returns generated by the hedge funds ranged from an aggregate gain of 2.8% over the 10-year period to a high of 87.7%. The S&P 500 investment generated a gain of 125.8%. The simple approach crushed the sexy, high octane approach. The hedge fund managers undoubtedly did well over the period collecting substantial fees from their investors. The investors likely earned significantly less.

These two victories of the simple over the complex lead us to wonder why complexity in the investment world is so pervasive? A year ago we read a great essay by Jason Hsu and John West called, “The Confounding Bias for Investment Complexity.”The authors argue that a preference for complexity is almost hardwired into investors. Investors seem to believe that only a complex solution can be successful in an investment landscape that is dynamic and mysterious. Of course, from an investment manager’s point of view, a complex strategy supports a higher fee. The investor wants to consume what agents and managers want to sell.2

Hsu and West then went on to their own analysis of the question of whether the simple or the complex is better. They conclude that on a before-fee and before-tax basis the two approaches will offer similar rewards on average. Of course, the complex strategy is likely to lag at least a little on an after-fee, after-tax basis. But this is not what causes Hsu and West to favour simplicity. The real argument for it in their minds (and in ours) is routed in psychology and behaviour.

The primary cause of investor underperformance, according to Hsu’s and West’s work, is the frequent hiring and firing of managers based on short-term performance. It is one way investors fall into the trap of buying high and selling low. Quite simply, an investor is overwhelmingly more likely to do this with a complex strategy than with a simple one. Intuitively, one is more likely to stick with a simple and straightforward approach when times get tough. Conversely, one is more likely to panic and jump ship when a complex strategy the investor doesn’t understand encounters tough times. Hsu and West go on to explain the behaviour using Daniel Kahnenman’s construct of System 1 and System 2 thinking that he outlined in his book, Thinking, Fast and Slow, in 2011. And there is much work in neuroscience that explains how the brain reacts to both pleasure and pain that also supports the basic explanation.

In short, it is no surprise that Warren Buffett, the greatest investor of our generation, exhorts people to use a simple and straightforward approach. It raises the odds that the vast majority of people will achieve investment success. For as Buffett famously said many years ago, “investing is simple, but not easy.” JCAS

1 Jason Hsu and John West, “The Confounding Bias for Investment Complexity”, Research Affiliates, January 2016.
2 Buffett sarcastically calls the agents and managers the “helpers”.

More Like This...

See another CRM2 blog post that may be of interest to you.

No posts found.

More Like This...

See another Foundations & Endowments blog post that may be of interest to you.

That Giving Feeling

Topic:
Foundations & Endowments, Tax Planning
Excerpt:
Summer is now a distant memory. In fact, a radio announcer declared only 77 days until Christmas. Ugh. It is usually in the last quarter of the year

More Like This...

See another Human Interest blog post that may be of interest to you.

Is COVID Giving You Scurvy?

Topic:
Human Interest
Excerpt:
The early ocean-going explorers learned the hard way that a lack of vitamin C can give you scurvy. And, according to Wikipedia, “the knowledge that

More Like This...

See another Inside Nexus blog post that may be of interest to you.

New Year, New Beginnings

Topic:
Inside Nexus
Excerpt:
It is with mixed emotions that we announce the retirement of Jorjan Mead from her position of Administrative Assistant with Nexus.

More Like This...

See another Investments blog post that may be of interest to you.

The Tail that Wags the Dog

Topic:
Investments
Excerpt:
We thank our friends at Northwood Family Office for having brought to our attention a fantastic book called, The Psychology of Money, written by...

More Like This...

See another Pearls of Wisdom blog post that may be of interest to you.

“Work, Work, Work, Work, Work, Work”

Topic:
Pearls of Wisdom
Excerpt:
This has been a busy year. I’ve had lots happening on the home front (a wedding!) and lots going on at the office (too long to list!) Managing work

More Like This...

See another Tax Planning blog post that may be of interest to you.

The (U.S.) Taxman Cometh

Topic:
Tax Planning
Excerpt:
Like the medical patient who expects to endure a fair bit of poking, probing and prodding from the doctor, clients of financial providers have had to

More Like This...

See another Wealth Planning blog post that may be of interest to you.

Estate Planning: Questions from our Virtual Chat

Topic:
Wealth Planning
Excerpt:
Helping clients with their estate planning is something we do here at Nexus. However, we are often involved in identifying the best tools for the

On a Side Note…

See another CRM2 Nexus Notes Quarterly article that may be of interest to you.

No posts found.

On a Side Note…

See another Foundations & Endowments Nexus Notes Quarterly article that may be of interest to you.

No posts found.

On a Side Note…

See another Human Interest Nexus Notes Quarterly article that may be of interest to you.

It’s About Time

Topic:
Human Interest
Excerpt:
Over the last 25 years, we have written frequently about time. In fact, in 2010, our annual client presentation carried the same title as this article

On a Side Note…

See another Inside Nexus Nexus Notes Quarterly article that may be of interest to you.

Building the Business: Another Virtual Nexus Welcome!

Topic:
Inside Nexus
Excerpt:
We are delighted to welcome Tom Wilson as the newest member of the Nexus team.

On a Side Note…

See another Investments Nexus Notes Quarterly article that may be of interest to you.

It’s a Topsy-Turvy Year: Investing During COVID

Topic:
Investments
Excerpt:
This year has been plenty weird. For starters, it feels like January was about five years ago… if you can remember it at all. Putting aside the health

On a Side Note…

See another Pearls of Wisdom Nexus Notes Quarterly article that may be of interest to you.

A Table for None, Please; Working From Home on the Rise

Topic:
Pearls of Wisdom
Excerpt:
Reading is one of the principal occupations in our profession. As we digest a wide range of material, interesting ideas and surprising facts – some

On a Side Note…

See another Tax Planning Nexus Notes Quarterly article that may be of interest to you.

The (U.S.) Taxman Cometh

Topic:
Tax Planning
Excerpt:
Like the medical patient who expects to endure a fair bit of poking, probing and prodding from the doctor, clients of financial providers have had to

On a Side Note…

See another Wealth Planning Nexus Notes Quarterly article that may be of interest to you.

Estate Planning: Questions from our Virtual Chat

Topic:
Wealth Planning
Excerpt:
Helping clients with their estate planning is something we do here at Nexus. However, we are often involved in identifying the best tools for the