The Needless Complexity of Investing
Incentives in the investment industry often promote complex strategies of little value
I wrote a version of this post five years ago after I left the investment management industry and before I joined the UK civil service. I was much closer to the industry then and more cynical because of it. I’m now a stronger believer in the importance of well-functioning capital markets in supporting business and economic growth, and the role of the investment industry in helping facilitate that. But that doesn’t mean I think the industry is without criticism, and I think the below holds up well.
Complexity pervades the financial sector. Whether in the jargon used, the number of products launched, or the obsession with quantitative techniques, complexity only seems to grow. Nowhere is this more so than in investment management, where an ecosystem of managers, advisors and consultants exist to navigate (aka make money from) this bewildering world.
Yet complexity often doesn’t serve the interests of consumers, whether directly through our savings accounts or indirectly through our pension schemes. Instead it serves as a barrier to entry and a constraint on functioning markets. It is the crux on which billions of dollars of fees are justified and yet it is often just noise.
Impenetrable jargon
The very language of investing is riddled with jargon at every turn: alpha, beta, convexity, duration, exotic, factor, gilt, high yield, index, J-curve, kurtosis, leverage, managed futures. We’re halfway through the alphabet already. So much jargon that a whole genre of resources explaining the jargon has sprung up around it.
Jargon allows those within an industry to communicate more efficiently but it also serves an economic purpose to keep others out. John Lanchester gives the example of the priesthood in ancient Egypt, who through the language and rituals they used, together with a network of Nilometers (measuring stations in temples to which only priests had access), controlled the knowledge of the Nile floods, the detail of which shaped every aspect of Egyptian life. “The world is full of priesthoods...”, Lanchester says:
“...On the one hand, there are the calculations that the pros make in private; on the other, elaborate ritual and language, designed to bamboozle and mystify and intimidate. To the outsider, the realm of finance looks a lot like the old Nile game.”
John Lanchester, The Danger of Financial Jargon, The New Yorker (July 2014)
Product proliferation
In an opaque world of formidable jargon, products proliferate as investment strategies that are essentially the same get repackaged into ones that sound different. And the incentive to do this is strong.
Launching a new investment product, be it unconstrained, multi-sector income, flexible allocation, long/short, is akin to setting the clock to zero or drawing a clean slate and starting again. There are low initial costs to create the product but huge economies of scale should the strategy succeed. After all, the resources needed to manage £100m are not that different to running £10 billion, but the revenues you receive are 100 times more. The logical approach then is for companies to launch many different products and see what takes off.
The late John Bogle, the founder of Vanguard and frequent critic of the investment industry, wrote about this phenomenon in Big Money in Boston, his 2013 essay detailing the evolution of money management. As Bogle puts it:
“...proliferation reflects (in part) a fund company marketing strategy that says, “We want to run enough different funds so that at least one will always do well.” An industry that used to sell what it made became an industry that makes what will sell.”
John Bogle, Big Money in Boston (2013)
The result is a universe of investment options of incredible complexity. Within the UK there are close to 4,000 Open Ended Investment Companies (OEICs) and Unit Trusts (equivalent to US mutual funds) spanning 50 sectors per the Investment Association (up from ~3,500 funds and 37 sectors when I wrote a version of this in 2019).
In the US the number of mutual funds was 8,763 at the end of 2022, up from 2,312 in 1987, per the Investment Company Institute.
FT Alphaville recently wrote about the growing complexity of the ETF landscape, with over 12,000 funds now listed globally. Add in different fund share classes, a whole other level of head scratching complexity, and you get tens of thousands of different investment options.
Some of this growth has undoubtedly been of benefit to the consumer, with the rise of low-cost index funds being the best example. But too often managers are just repackaging different market returns (“betas” to use the jargon) in different guises. Multi-sector income funds, for example, are often no more than combinations of riskier corporate bonds with some equities thrown in. It is questionable whether they are of more value to an investor seeking income than a simple portfolio of index-based equities and bonds, delivered at a lower cost.
Returning to Bogle…
It remains to be seen whether this quantum increase in investment options, ranging from the simple and prudent to the complex and absurd, will serve the interests of fund investors. I have my doubts, and so far the facts seem to back me up.
John C. Bogle, Big Money in Boston (2013)
I have my doubts too.
Quantitative engineering
The incentive structure of the industry supports complexity but so does the type of people populating it. In this post, Lisa Pollack asked “Why are we so good at creating complexity in finance?” Her answer: the Flynn effect, the observation that intelligence scores have increased over time. In short, we are getting better at abstract thinking as each generation passes, so smarter and smarter people are creating more and more complex solutions.
I don’t know much about the Flynn effect and there seems to be some controversy around it, but I think there’s something in the argument about complexity begetting more complexity that rings true. Through its very subject matter, the financial sector sucks in quantitative thinkers. It is populated by economics graduates with an inferiority complex about their quantitative skills relative to the mathematicians and engineers they work alongside.
This focus is reflected in the world of academia. Researching the first version of this article, I struggled to find anything good on the structure of the investment industry, the value proposition for investors and its impact on society. I could however find a gazillion papers discussing the optimal investment strategy for this and that, or some arcane risk factor that had just been “proved” (which five years later turns out not to matter…).
And yet is all this research and data mining and collective brain power expended really of any benefit? Across the market as a whole, the underlying returns are what they are. The economy is only growing so fast: companies are only producing so much; workers are only earning so much. The rest is just financial engineering (aka how many ways you can use debt to enhance returns).
Are we doomed to more complexity?
If you cut through the arguments, there are two main drivers to complexity in investing.
First, the incentives of the industry drive more complex solutions to justify the fees of everyone within it. Here’s the FCA on the investment consulting industry (institutional too, this isn’t just a retail problem):
“The business model of consultants, in particular their hourly rate charging structure, creates incentives for them to recommend complex investment strategies to clients. Clients in more complex investment strategies require more time spent on researching strategies, running manager selection exercises, undertaking trustee training and eventually more ongoing monitoring – all of which justifies higher fees for consultants”
FCA, Asset Management Market Study Interim Report
This is true across the value chain: fund managers, investment consultants, financial advisors, you name it.
Second, complexity begets more complexity as clever people are sucked into the industry and compete against other clever people to capture outsized rewards.
Across society, however, this complexity is arguably worthless, and investors would be better served with a narrower range of simpler and lower cost solutions. But then where would the investment industry be?
Final thoughts
When I was working in investment management, I used to think a lot about toothpaste. The world doesn’t need hundreds of varieties of toothpaste, I’d reason, but we still have them, because in a capitalist system, people have decided they value variety and choice, and will pay for that, and through marketing and branding, companies have worked out how to de-commoditise what could/should be a commodity product. And because of that the toothpaste industry is larger than it would be if toothpaste were a commodity, which creates more wealth, which is good for society, etc. etc.
Which is where I got to with the investment industry and the myriad products within it. The complexity of the product offering doesn’t create any better investment outcomes overall; but perhaps people investing derive some utility from the choice. Clearly that begs the question of whether there are negative economic and social consequences of a large finance industry versus a large toothpaste industry. Many would argue there are, given how finance underpins other economic activity, and how any downturns in the sector reverberate more widely. But that’s a much bigger topic than this post.
Personally, I like to keep investing simple. Keep costs low and understand what you’re investing in. Pick individual stocks if you’re interested, but for most people, buying an index fund and forgetting about it will be the best option.