Complexity, concentration, leverage, and illiquidity are the four horsemen of the investor apocalypse, perennial threats that wreak havoc on portfolios and undermine even the best-laid plans of diligent investors and their advisors. Unfortunately, these same four horsemen are also profit generators for Wall Street, thus creating a continual tug of war in investment management between what’s advantageous for the provider and what’s beneficial for the investor.
Consider Jack Bogle’s beloved traditional index fund. This investment averts the four horsemen at every turn. It is simple, diversified, unleveraged, and highly liquid. In contrast, the typical hedge fund is complex, concentrated, often leveraged, and generally illiquid. The differences are reflected in their pricing. The perceived sophistication in the hedge fund allows its purveyors to charge higher prices, while the simplicity of the index fund commoditises the offering and demands a low price. That’s why cost is such an effective first-stage screen in selecting investments: not only do lower-cost investments save money, but they also keep the four horsemen at bay, thus upping the odds of investor success.
The four horsemen provide a useful rubric for evaluating an investment’s potential to serve investors well. Given this backdrop, it was dismaying to read the agenda of a recent high-level gathering of asset managers. The topics included alternative investments, the asset-gathering success of a concentrated active fund, and the emergence of a new generation of brokerage firm that makes trading stocks seem like a game but still carries the traditional brokerage practice of offering margin accounts. Each of these activities summons one or more of the horsemen.
Zigs and Zags
Alternative investing was the central topic. The theoretical benefits of alternatives entice. Something that zigs while the rest of a portfolio zags could protect investors in tough times. But after more than two decades of experimentation with alternatives in the retail mutual fund space, there is little evidence that investors have benefited. Alternatives get promoted not at peaks where they might protect from declines, but at troughs where they limit participation in rebounds. As former Clipper manager Jim Gipson noted, the popularity of an investment idea approaches its zenith as its utility approaches its nadir. Such has been the case with retail alternatives, where all four horsemen have at times undermined results. Even professionally managed target-date funds have failed to demonstrate how alternative investments can be deployed in a portfolio to provide tangible aftercost benefits for investors.
That won’t stop Wall Street from trying. The jaw-drop slide of the conference compared the market capitalisation of Blackstone (BX), which specialises in alternative investments, with BlackRock (BLK), a dominant player in more traditional and, especially, indexed funds. The big takeaway was that even though Blackstone manages a smaller amount of client assets, it is accorded a higher market capitalisation. The lesson is clear: The easier path to success isn’t playing the scale game of managing low-cost, unleveraged, broadly diversified investment options, but through launching pricier, more complex fare.
The four horsemen don’t only ride in alternatives. A concentrated thematic investment fund was a further topic of conversation at the conference. Personally, I admire managers who bet big on their best ideas, but we’ve seen this show before and know by now that such funds rarely produce good investor outcomes. Consider the Janus funds of the late 1990s that brought in huge sums (aided by high-profile advertising) at the peak of the tech bubble. Or Ken Heebner’s very concentrated CGM funds that earned him cover-story praise from a glossy business magazine in June 2008 as America’s Hottest Investor, just before the financial crisis hit.
For the full calendar year of 2008, America’s hottest investor singed client assets to the tune of a 48% loss in his CGM Focus (CGMFX). Concentration brings higher highs, but it also brings out the worst in investor behavior, as many are tempted to buy at the peak. Until Wall Street finds a way to help investors better harness these funds, they will be better bets for their issuers than their buyers.
Leverage, Frequent Trading, No Research
Another hot topic was a retail brokerage where investors have been chasing meme stocks. I’m all for greater access to markets, but I shudder to think of the real-world consequences of frequent trading in stocks on which you’ve done little to no research. The tax-filing implications alone are a complexity headache. A bigger concern, one not unique to any particular brokerage, is the widespread use of leverage. If a Yahoo Finance-Harris poll is to be believed — and the results seem stretched to me — 43% of retail investors leverage their investments through options or margin accounts. This will not end well. Public mutual funds have a rotten record using leverage — and they are the pros. Retail investors are unlikely to fare better. While much has been made of the liquidity issue over GameStop (GME) when trading was temporarily curtailed, the horsemen of concentration, tax complexity, and leverage are equally ominous.
The four horsemen also loom large in private equity. Complexity, concentration, leverage, and illiquidity are all in play here. While there’s much theoretical appeal to giving smaller investors access to private markets, the tug of war to determine how much of these benefits will flow to investors after costs has yet to play out. If special-purpose acquisition companies offer foreshadowing, small investors’ odds look grim. Private equity has the qualities that make it something Wall Street will be eager to sell; it will take great skill to make it something wise investors should buy.
Editor's note: This article first appeared in the Q2 2022 issue of Morningstar magazine. Click here to subscribe.
