Research Affiliates: The Confounding Bias For Investment Complexity

January 21, 2016

Key Points

  1. A preference for complexity is almost hardwired into investors, their agents, and asset managers because the intuition is that a complicated investment landscape requires a complex solution; a complex strategy also supports a higher fee from both agents and managers.
  2. Research shows that simple, low-turnover and complex, high-turnover strategies perform similarly on a before-fee basis, suggesting the former may have the advantage after tax.
  3. Simplicity leads to better investor outcomes not because simplicity in and of itself produces better investment returns, but because a simple strategy encourages investors to own their decisions and to less frequently overreact to short-term noise.

“Simplicity is a great virtue but it requires hard work to achieve it and education to appreciate it. And to make matters worse: complexity sells better.”

Edsger W. Dijkstra1

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.

 

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