A car is faster than a bicycle, a plane faster than a car. Apes are smarter than trees, humans (most anyhow) smarter than apes. Examples of higher complexity leading to better results are all around.
However, when it comes to investing, this is not the case. Hedge funds, as a group, have been unmasked as (mostly) manager compensation schemes and a few weeks back I highlighted a paper on how dumb so-called ‘smart-beta’ strategies are (this link will take you back to that Dumb-Beta and here’s just one of many, many stories about what a bad idea hedge funds are Bad Hedgies!)
The paper highlighted this week from Paul Calluzzo, Fabio Moneta and Selim Topaloglu, all from the Queen’s University – Smith School of Business looks at the use of leverage, short-sales and options by that part of the industry most closely associated with steady-Eddy investing, mutual funds.
This is the first study to look at the use of complex instruments by mutual funds in an holistic manner. Previous studies have looked at issues in a more prescribed fashion and been inconclusive on whether the use of these instruments/strategies is a good or a bad thing. This study concludes with no such equivocation.
‘..[The Study] results suggest that the use of complex instruments is associated with outcomes that harm shareholders [Of mutual funds]: lower returns, higher unsystematic risk, more negative skewness, greater kurtosis, and higher fees.’
It gets worse. Increased use of leverage is often associated with a period of under performance as desperate managers attempt to double-up-to-catch-up (it never works). Writers of options do better than buyers but the former can’t resist playing in both so the effect is wiped out and, perhaps most disturbing of all, the shabbiest practices seem to take place in funds with the highest concentration of retail-rubes.
The moral is clear. Next time you’re thinking of investing in a fund, mutual or otherwise, be sure the managers have a demonstrable track record of success with complex strategies if that’s part of their remit. In fairness, some people really are good with these things. I know and have worked with very accomplished operators; but there are more than a few numpties, as the paper highlights, also trying their hands.
You can access the paper in full via this link Fund Complexity and Returns.
Happy Sunday.