Complexity Risk - the silent killer of investment returns

Five years ago I published a white paper entitled "Complexity Risk: A New Risk Category".  In it, I defined "complexity risk" as the potential for an investment to generate returns that are different than those anticipated.  Investments like short term U.S. Treasury bills are the least complex.  Indeed, they're so simple they don't even have a prospectus.  You buy them and in three months you get your money back, plus interest at the stated rate.

However, other investments appear to be just as simple but are wildly complex under the surface.  Like Double Jeopardy, the investment "scores" can really change on these, and usually to the downside.  Many insurance and structured products are like this.  At the surface level, they appear to be as simple as the three-month U.S. Treasury bill.  One level down, they explode in complexity.

Importantly, my paper also discussed how investment complexity was a type of risk unto itself, which should be managed.

Five Years Later - Has Anything Changed?

The short answer is "no".  While index funds and ETFs (low complexity investments) have continued to take in assets, lower interest rates have caused advisors to recommend more alternative investments.  These are comprised primarily of private equity, venture capital, hedge funds, and other direct investments.  They are all highly complex, sometimes due to their underlying investments, and always due to their structures.

Elsewhere, Collateralized Debt Obligations ("CDOs") have become Collateralized Loan Obligations ("CLOs"), and volatility selling strategies have multiplied like monsoon frogs.

Despite my writings, and those of a few others in finance, complexity risk has continued its march, unabated.  The front line of this battle is investment products that are sold by broker-dealers, and, to a lesser extent, registered investment advisors.

Complexity is rarely in the client's best interest.  (You didn't think the 20 page, six-point font, credit card agreement was written for your benefit, did you?)  Indeed, it is almost always used against the client to hide fees and risks, and there have been many instances where products sold to clients were so complex that even the professionals selling them didn't understand.

Complexity v. Investment Risk - an  Example

If an investor has all of her equity investments in an S&P 500 Index ETF, the complexity risk of that investment would be low.  However, the investment risk of the investment would be high.  (As anyone who has been invested in the stock market for the past 20 years can tell you, the S&P 500 has declined by around 50 percent twice over that period.)

Comparatively, an investment in a hedge fund that was benchmarked to the S&P 500 Index would almost certainly have very high complexity risk.  This is due to the variety of strategies used, fee structures, potential to gate investors (i.e. not let them have their money back), use of leverage, etc.

The difference between the two investments is that the S&P 500 Index ETF is unlikely to generate performance that is really surprising.  It might go down 50 percent, or more, but we've seen that before, so it's expected.

The hedge fund, however, could go to zero for a variety of reasons.  Since hedge funds are frequently marketed as being low volatility, this would be a surprising outcome.

In short, both complexity and investment risk can destroy your investments. The difference is that with complexity risk the destruction would have likely been unexpected.

Complexity Risk Budget

One way investors can protect themselves is to have a complexity risk budget.  Very simply, this is the percentage of a portfolio's investments that will be allocated to complex investments.

In my experience, the complexity risk budget should be zero on the fixed income side and low on the equity side.  Complex fixed income investments have a particularly bad track record caused by trying to prevent declines (aka provide "stable value") and using leverage, frequently at the same time.

As discussed above, limiting complexity risk does not limit investment risk (defined either as volatility or a permanent loss of capital) however it will help to eliminate unexpected, and frequently catastrophic, investment declines.

Uncompensated Risk

Unfortunately, most investors are not being compensated for taking complexity risk.

The classic example of this is from the Global Financial Crisis, when many institutional investors were invested in CDOs that gave them only marginally higher yields than a comparable U.S. Treasury note.

Of course, the CDOs were wildly complex and many investors took large losses on them even though they were AA or AAA rated.

If complexity risk is taken, the investor needs to be compensated richly for it.

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