In the post-2008 world of investing, keeping it simple is in vogue. After all, complex investments came to be known as instruments of mass financial destruction as they brought the global financial system to its knees. By comparison simplicity seems attractive. Yet simplicity in and of itself is not necessarily a good thing for investors.
As we now know, complex securities and the derivatives that were tied to them acted as the catalyst for the biggest bankruptcy in US history, the downfall of Lehman Brothers. Lehman and many others were victims of their own success in selling complex financial instruments. But it became apparent when the crisis hit that remarkably few people – including some that were involved in selling the products, as well as investors – truly understood their full complexity and the extent of their exposure.
Consider the example of Michael Burry, whose story of dropping out of medical residency to set up hedge fund Scion Capital is chronicled in Michael Lewis’ recently published book, ‘The Big Short’.
As Lewis relates, "Every mortgage bond came with its own mind-numbingly tedious 130-page prospectus… Burry spent the end of 2004 and early 2005 scanning hundreds and actually reading dozens of the prospectuses, certain he was the only one apart from the lawyers who drafted them to do so." Little wonder that in the volatile and unpredictable world that investors have had to inhabit since these complex securities came unravelled, many have shunned complexity.
Yet Burry’s efforts to gain an information advantage in the complex world of mortgage bonds, a struggle that few were willing to undertake, eventually paid off. Burry saw that many of these securities were destined to failure, but realising there was no way to bet against them, he became a catalyst for the creation of a new form of complex security that could.
Another of the few investment strategies to work during the credit crisis were commodity-trading advisors, a type of hedge fund which makes use of derivatives to capture directional moves in the financial markets. While not well understood by many investors, they were able to post gains when just about everything else was falling.
Simplicity doesn’t necessarily bring rewards
And of course, simplicity doesn’t necessarily bring rewards. Some seemingly simple investments – like money market funds or Greek and Irish government bonds for example – have shown that they have the potential to wreak havoc on even a relatively conservative investment portfolio.
So is it simplicity investors are seeking, or have they simply lost trust in financial markets and just want to park their money where they can easily get it back? Trust in the world’s major financial institutions was one of the major casualties of the credit crisis. Now, at least in the euro-zone, the credibility of policy-makers seems to be lurching lower as the credit crisis gives way to debt crises and the potential for another recession in some peripheral euro-zone countries.
From March 2009, with the banking system stabilised and economic recovery in sight, appetite for risk ballooned and risk assets like commodities, corporate bonds and equities came into their own again. But uncertainty stemming from Europe’s fiscal crisis and a weakening recovery had put many investors off risk-taking once again. Safe-haven assets, such as US and German government bonds, which are transparent, liquid and readily understood by investors, came back in high demand.
While this has undoubtedly reinforced the desire for simpler, more transparent and liquid assets, investors have to consider where the potential lack of these characteristics comes from, and whether they are receiving adequate compensation for taking on the associated risks.
Transparency and liquidity
In the case of liquidity, there is a clear trade-off between the desire for access to cash and the ability to generate returns over the long run. The main risk here is a mismatch between this desire and longer-term investment objectives. However, with the experience of the credit crisis still fresh in investors’ minds, renewed volatility is clearly causing many to re-examine their willingness to forfeit liquidity.
The traditional argument for lack of transparency is to protect managers’ ‘proprietary’ trading strategies, but we are now seeing an increasing willingness to make information available to clients. Ultimately, it is down to the individual investor and their advisers to determine whether the potential rewards outweigh the risks where lack of transparency is involved, with the balance clearly tipped towards caution.
With all the uncertainty and complexity of globally interconnected financial markets, preserving and building your wealth is no simple task. The ability of skilled, experienced professionals to understand and analyse the relevant information is crucial to the ultimate success of clients’ investment strategies. We believe identifying risks is also at the heart of successful wealth management, and a consistent theme in all our work is to identify risks and consider how various asset classes will interact across a range of economic scenarios.
Please note the value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment.
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