A lot of investors believe that when it comes to investing, the best thing to do is to "keep it simple." I respect this approach–to a point.
You could do a lot worse than building a portfolio of "simple" assets (stocks, bonds, cash, low-cost ETFs or mutual funds) and leaving it more or less alone. Indeed, this may be the ideal approach for those who have little interest in keeping up with the market, or those determined to be do-it-yourself investors.
However, complexity is in the eye of the beholder; what's complex to you may not be complex to the next person. More to the point, there are considerable benefits to investments that are typically considered "complex."
Two examples are long-short/market neutral hedge funds, and private equity funds or pools. While the mechanics of these investments aren't always easy for non-professionals to understand, they can offer excellent diversification and performance that is largely uncorrelated to traditional assets–two features of critical importance to high-net-worth individuals.
To dismiss investments just because they're complex seems reductive to me. "Complexity" is nothing to fear in and of itself. Far better to take a deep look at that complexity, and ask some important questions about its features. With that in mind, allow me to offer the following features that we look at when we evaluate complex investments in our practice.
Is there regular reporting and verification?
One of the advantages of investing in stocks, bonds, and cash is you always know what your investment is worth. That's an essential tool for any buy, sell, or hold decision you may make.
Valuation is more difficult with complex investments, because they are often built around illiquid or hard-to-value assets. But that's no excuse. All assets should be valued on a regular basis, in accordance with GAAP. That valuation should be performed by a respectable, qualified third party (as opposed to internal management) and should be audited by a major accounting firm with a good reputation.
This is the first and most important criterion for evaluating any investment in our practice. Complex or simple, if a given investment doesn't pass this test, we avoid it.
What are the fees?
Fees for complex investments are generally higher than those for simple investments. After all, it doesn't cost much to track a stock index. Managing a business (private equity) or setting up an ongoing series of paired long and short trades (hedge funds) requires considerably more time and effort.
Even so, the fees on some complex investments are, quite frankly, shocking. Not only do high fees make it difficult for investors to generate a meaningful return, they also create a "disconnect" between the interests of investors and management. When managers can make money even if the investment they're managing doesn't perform, there is little incentive to do one's job well.
In our practice, we pay a lot of attention to fees and what they tell us about management. If costs aren't disclosed with a simple, easy-to-understand management fee, that's a serious red flag. So is a fee structure that removes "pay for performance" incentives.
How much leverage does the investment use?
Leverage (borrowing to invest) is an important financial tool. Many "simple" investments utilize leverage: corporations often issue bonds and commercial paper to re-invest in their businesses. Many REITs do the same in order to pay for acquisitions.
But with complex investments, leverage requires more caution. Many complex investments utilize leverage as a way of producing outsized returns, and this can lead to "double leverage" situations: the underlying asset uses leverage, then the fund itself is levered again. Even if the amount of leverage in the underlying asset is reasonable, the double layer can dramatically increase risk. Even worse is if that double layer is hidden or obscured, or buried deep within a prospectus.
In our practice, leverage isn't necessarily a deal-breaker, but it's something we investigate and monitor closely. In general, we avoid double leverage situations.
Does it pass the 'smell test'?
Most of the successful investors I've met (professional managers, peers and colleagues, HNW business owners, etc.) have a keen sense of when something feels right and when it doesn't.
Over the course of my career, I've learned to develop and trust my financial intuition. If an investment seems too good to be true–its performance is too good or too consistent; information doesn't make sense or is incomplete; something just rubs you the wrong way–I've learned that it's best to take a pass.
Thane Stenner is founder of StennerZohny Investment Partners+ within Richardson GMP Ltd., as well as Portfolio Manager and Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)'. (www.stennerinzohny.com) The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.