30 Jan Are You in Investment No-Man’s Land?
In my last post, I talked about investments as falling into one of two categories: passive index funds, and actively managed funds. More precisely, investments really fall into four categories or quadrants, drawn by two axes, the (vertical) cost-complexity axis and the (horizontal) strategy axis.
The chart above illustrates the concept of these investment quadrants and what they mean.
The vertical axis runs from simple, low-cost up to complex, high-cost. The horizontal strategy axis goes from passive to active. Roughly the quadrants can be described as:
- High cost/complexity with a passive strategy.
- Low cost/complexity with an active strategy.
- Low cost/complexity with a passive strategy.
- High cost/complexity with an active strategy.
No. 1 is bad for fairly obvious reasons. An expensive and complicated but passive strategy makes little sense, because you are paying a lot of money for what is essentially an expensive index fund. If you are paying for a passive strategy like an index fund, it should be inexpensive. Many wealth management and investment advisory firms are guilty of this type of strategy. If you’re in this type of fund, you’re probably asking yourself why you’re paying so much for less than stellar performance.
No. 2 sounds good on the face of it, a low-cost, actively-managed fund, not complex in nature. But the truth is that its performance is probably the result of luck and not sustainable. Over the long term higher returns are probably going to prove elusive, or at minimum be infrequently repeatable. Here is something to keep in mind: Statistics show that over 75% of actively managed funds don’t outperform their respective benchmarks. It gets even worse than that because of the 20 or 25% of that do outperform, the composition of the group changes every year. This means that finding sustainable outperformance is a tricky proposition.
These two quadrants are what I call investment no-man’s land, and you’ll want to avoid them.
Nos. 3 and 4 are where you want to be, although neither is perfect.
An inexpensive passive strategy is relatively cheap and simple to employ – but there are variations in how to manage portfolios in this realm, everything from do-it-yourself “simple-index” strategies, efficient and scalable robo-advisor approaches, and “smart” index strategies than can allow for more flexibility and optimization in portfolio design. In all of these variations, costs and complexity are low, and returns are consistent with broad market indices.
No. 4 can bring returns that consistently outperform the market, but this usually comes with increasing levels of active management, expanded risk, higher costs, tax management, and fees. In short, complexity is high. It can also require a higher than normal degree of illiquid investments, which is an important consideration in financial health. In our opinion, to be successful in this quadrant requires investment assets in excess of $10 million and really is best suited for investors with assets north of $25 million.
So where should you be? Like many things in life, it depends: on market conditions, economic environment, and personal circumstances and objectives.
At Highland, our approach is in most cases to focus on quadrant 3, and specifically find that sweet spot which moves the point of reference in the direction of where the axes intersect. That’s what we mean by a “smart” index approach. This more optimized approach is built around the belief that we can create a portfolio smarter than one a client could create on their own, keep it mostly passive in nature, and still preserve the flexibility for active management when appropriate.
In a future post, we will discuss other, simple value-added returns we can provide without the added cost, complexity, and risk of chasing outperformance. For most business leaders in high growth companies, the goal needs to be avoiding investment no-man’s land and just getting smarter!