Thursday, April 3rd, 2014
chasing complexity

Six years ago, the evidence was rapidly mounting that a new generation of structured products had given investors exposures that they didn’t understand, had given the management teams of the largest financial companies exposures that they didn’t understand, and had given central bankers exposures that they didn’t understand.

Within a few months it all came crashing down.  Thankfully, we learned our lesson.  Didn’t we?

That same year, 2008, Lawrence Kochard and Cathleen Rittereiser published Foundation & Endowment Investing.Wiley | The first part of the book is an overview of the institutional investment landscape.  The second is the story of individual chief investment officers and the strategies and stories of their organizations and investment lives.  At one point, the authors referenced The Paradox of Choice,the research puzzle | I wrote three postings on the book.  This links to the first of them. by Barry Schwartz, saying, “The complexity of choice will challenge foundation and endowment CIOs in the years ahead.  There are more opportunities, more risks, more asset classes, more products, more intellectual capital, more technological advances, and more competition for good information, ideas, and investments.”

The first aspect of that challenge was just navigating the financial crisis that ensued.  But that didn’t bring a halt to the complexity and didn’t really slow down the move toward more of it, in spite of the trauma.  Once the liquidity crisis passed, many opportunistic institutional investors tried to find value in the wreckage, adding complexity in many cases rather than subtracting it.

And others followed along.  Now many large investors have portfolios that are unrecognizable in comparison to what they were not that many years ago.  Just describing the holdings in a simple fashion is a challenge.  The asset classes might have basic labels, but lying within are all different sorts of structures, with exposures that might not fit our preconceived notions of those categories.

“Where we draw the lines”the research puzzle | That was the title of an early posting on this blog, also from 2008. matters a great deal.  One chief investment officer interviewed for the Kochard and Rittereiser book said that “the borders of the asset classes are melting.”  They have continued to do so in the intervening years — understanding a portfolio from the top down has gotten more difficult and looking at individual positions from the bottom up can be positively baffling for those not familiar with the range of institutional investment vehicles of today.

Last week I attended a half-day seminar at CFA Society Minnesota, “Where to Invest in a Rising Rate Environment.”Freezing Assets | This is a write-up of the seminar on the society’s blog (for which I occasionally write).  It included presentations by investment managers and institutional investors.  The unavoidable conclusion for this attendee was that because of the low-rate environment and the expectation that rates will rise, investors have migrated into significantly more complex strategies.

The same thing has been occurring in the retail world too, with the breathless rush into alternatives and the increased popularity of unconstrained mandates, niche strategies, and tactical overlays in more traditional areas.

What will come of all of this increased complexity?  History will unveil for us a pattern of risk and return — and it may also reveal our lack of understanding.  Let’s hope not.

In the meantime (as always), I encourage investment organizations to focus on developing better ways to analyze and report their exposures.  The informational architecture always lags investment progress, which impedes good decision making.  This time is no different in that regard, although the gap is probably wider than normal given the increased complexity.

Furthermore, the burden for communication of that complexity falls on the investment providers, not on their clients — and on the investment staff and consultants that serve institutional trustees, not on the trustees.  There are lots of conversations left to be had.

Chasing complexity is not necessarily bad, but if understanding lags too far behind, the surprises can be devastating.  It’s time to catch up.