Research Affiliates: Elegant Design

Key Points

1. The AND principle holds that creative product design can surmount some trade-offs that conventional thinking considers unavoidable.
2. Simple investment strategies are easier to govern than complex ones and may be less likely to result in catastrophic outcomes.
3. A simple new design demonstrates that income-oriented indices need not trade off yield for capacity and quality.

"When you first start off trying to solve a problem, the first solutions you come up with are very complex, and most people stop there. But if you keep going, and live with the problem and peel more layers of the onion off, you can often times arrive at some very elegant and simple solutions."

—Steve Jobs¹

In January 2007 Steve Jobs announced a revolutionary product: the iPhone. Before that, phones were either easy to use but only had a single function, or multi-functional ("smartphones") but hard to use. The conventional wisdom in phones, as in many areas of product design, was that trade-offs are inescapable: the consumer simply cannot have everything she wants delivered in one appealing product. But with the historic unveiling of the iPhone, Jobs proved the conventional thinkers wrong. The iconoclastic iPhone design showed that the consumer can enjoy a product with rich functionality and ease of use. We call this the AND principle. It guides all of our new product designs. Instead of accepting unnecessary trade-offs, we seek to combine the qualities investors desire in a single vehicle.

But before we explore the AND principle in more depth, let's review two important elements in product design: structure and implementation.

The Challenge Of Simplicity

"That's been one of my mantras—focus and simplicity. Simple can be harder than complex."

—Steve Jobs²

Structure is essential to product design. Structure can be simple. Structure can be complex. We agree with Steve Jobs that simplicity is often the more difficult to achieve, but we believe it improves on complexity in two major ways. Simple solutions 1) lead to more predictable outcomes, and 2) allow cleaner and easier oversight.

In the investment world, complexity leads to crises, crashes, and fund collapses. A short list of events over the last three decades in which complexity played some role includes the 1987 stock market crash, the late 1990s Long-Term Capital Management collapse, the 2000 bursting of the dot-com bubble, the 2007 quant meltdown, the 2008 global financial crisis, and the 2010 flash crash, among others. Simple strategies are exposed to unpredictable events—especially those with systemic effects—but, compared to more intricate structures, the way they will react under stress may be easier to grasp, transactions easier to unwind, assets easier to locate, and ownership easier to establish. (Recall the difficulties Lehman's counterparties encountered when they tried to claim derivatives collateral after the firm filed for bankruptcy in 2008.³) Simple strategies may be less likely to result in catastrophic outcomes.

The second important advantage of simplicity is easier governance. For institutional investors, it means that an officer can understand and coherently explain to the board what the strategy is doing. Also, during periods of underperformance (let's not kid ourselves, periods of underperformance are inevitable for any strategy), this ability to understand what the strategy is doing helps investors stay with the strategy. For individual investors, simplicity means that at the next BBQ party they will be able to explain why they are staying with the strategy instead of switching to some new "bright and shiny" magical stock that their neighbor just bought.⁴