Target-date mutual funds are examples of complex investments, while plain-vanilla investments like traditional ETFs are simpler—and more profitable.
One of the cardinal rules of successful investing is to invest mainly in simple, plain-vanilla investments. This rule limits your choices to two main categories: stocks and bonds (and we think most Successful Investors should focus on stocks). By confining yourself to these two investment categories, you still have all the investment choice you need. You also avoid the hidden risks and conflicts of interest that you’ll find in more complex investments.
The funny thing is that the promoters of complex investments typically describe the features of these investments as if they were benefits, disregarding the associated negatives. This marketing approach attracts investors who want to make a quick decision. These investors tend to accept the sales pitch at face value.
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Target-date funds as an example of complex investments to avoid
These mutual funds take advantage of the widely held view that bonds are inherently safer than stocks, so you should gradually shift your investments out of stocks and into bonds as you near retirement. Target date funds do this for you automatically.
Investors buy these funds with a target date that is near the year when they plan to retire. Managers of target-date funds generally invest in a mix of stock and bond mutual funds from the investment company they work for. As years pass, the managers gradually reduce their stock-fund holdings and increase their holdings in bond funds, while remaining within the fund family.
When interest rates and inflation move upward, as they eventually will, bond market returns will shrink or turn into losses. This will cut into the gains (or expand the losses) on the target fund’s stock-market holdings.
Meanwhile, the investors will suffer from conflicts of interest that are being settled in favour of the fund family.
For example, when target fund managers need to buy a fund, research shows they tend to favour new funds, particularly those in operation for three months or less. This works in favour of the fund family, because it helps get the new fund off the ground. It works against the interests of the investors, since new funds tend to underperform comparable funds for their first three years in operation.
Also, some target fund managers seem to prefer moving into higher-fee funds—MERs (Management Expense Ratios) of up to 0.4% more than alternate funds. Here too, that’s good for the fund family, but bad for the fund family’s clients.
Advisors who sell complex investments defend them with offhand observations like “You could do a lot worse.” That’s true. But it glosses over the two key drawbacks of complex investment products.
First, they tie you to an investment strategy that could have hidden flaws. The strategy could work for a while, then suddenly quit working, and generate losses instead of gains.
Second, the design of a complex investment product ensures that it will expose you to conflicts of interests. The operators are bound to settle some conflicts in ways that work against your interests. You might even say these products are designed to create conflicts of interest that the operators can exploit.
Other complex investments to avoid
Some complex investment products profess to offer a “deal” that has more profit potential and/or less risk than you get from plain vanilla stocks and bonds. In our experience, what you lose on the one side of the promise is more valuable than what you gain (if anything) on the other. The deal in investment products is, however, much more complicated than the deal on the plain vanilla alternative.
It’s easy to find references to the hypothetical gains and advantages of investment products—just look in the marketing brochure, or ask the salesperson. To find out the downside of the product, you have to dig through many pages of legalese/fine print. The seller always has an information advantage over the buyer.
As a group, these products are likely to provide a lower long-term return than what you’d expect from a portfolio of high-quality stocks picked using our Successful Investor philosophy. But they provide a higher return to the salespeople, compared to what they can earn by selling you a portfolio of high-quality stocks.
Traditional ETFs are not complex investments and they may provide simpler, more profitable investment options
Traditional ETFs practice “passive” fund management, in contrast to the “active” management that conventional mutual funds (or some new ETFs) provide at much higher cost. Traditional ETFs stick with this passive management—they follow the lead of the sponsor of the index (for example, Standard & Poor’s). Sponsors of stock indexes do from time to time change the stocks that make up the index, but generally only when the market weighting of stocks change. They don’t attempt to pick and choose which stocks they think have the best prospects.
The MER (Management Expense Ratio) is generally much lower on ETFs than on conventional mutual funds or actively managed ETFs. That’s because most ETFs take a much simpler approach to investing. Instead of actively managing client investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.
This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.
Have you invested in confusing, complex investments? What did you see as the most problematic parts of these investments?
Target-date funds are increasingly controversial. What’s been your experience?
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