Simple Investments, Complex Investments

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What’s your investing guilty pleasure?

For me, it’s complex, esoteric stuff: The more creative, the better, especially when it comes to financial services companies or structured transactions. More than once have I invested in convoluted, hard-to-understand opportunities. Sometimes those worked out well. Other times, they didn’t, because the market didn’t end up sharing my complex thesis.

Professional investors such as private equity funds often say that they create value from complexity. Whether it’s a complicated carve-out of a niche business from a large conglomerate, a distressed transaction or a three-way-merger - it’s those types of deals that not everyone can do that might have the potential for outlier return. But just as with my personal trades, that doesn’t always hold true: One of my favorite GPs to talk to - also a master of carve-outs - has returns that are good, but definitely not great, as they should be given the level of complexity of their deals.

Which brings us to today’s topic: The often-debated conflict between Simple and Complex Investments.

The Case for Complexity

A lot of affluent individuals that I speak to are drawn to complexity. After all, a lot of them made their money as founders and CEOs of cutting-edge, innovative companies, and want to bring this ingenuity and creativity to their personal investments. 

And I can understand that. Investing is a fun, intellectual exercise. Everyone thinks they can beat the market. And it’s also something to talk about: Nobody wants to sit at a fancy dinner with their friends and talk about how they’re invested in an ETF.

That last part is also key to the fallacy of complexity: You only ever hear from GPs and individuals about the complex investments that go well. Few people talk about their complex investments going sour, and even less do they talk about the significant pain associated with unwinding a complex investment. Last year a fellow investor told me proudly about a niche, somewhat complex investment structure they’d envisaged offering not only great returns but also regulatory arbitrage. When I recently saw him and asked him about how that structure was doing, he was disgruntled - their complex investment had another complexity they hadn’t thought about, and a lot of his time now went into unwinding the structure.

Of course there is also a financial case in favor of complex investments given their attractive returns. If they are properly structured and all their risks are known and mitigated, they offer the holy grail of investing:  Asymmetric returns. Such investments have limited downside (as complexity is often reflected through a lower price), but significant, uncapped upside. An investment that comes to mind is Paul Singer’s infamous battle with the country of Argentina about their defaulted government bonds, lasting 15 years and going as far as having his hedge fund seize an Argentinian military vessel. In the end, Singer won - and earned a return of 1.2bn. billion (!) dollar return on an investment estimated to be between 132 million dollars and as little as 26 million dollars. 

So maybe complex investments are not worth the effort when they go south, or offer just average performance - but they more than make up those downside scenarios for the returns they offer when things go right. That sounds a little bit like the pitch for active management, and beyond that, the so-called Yale Model (also called the Endowment Model): A strong focus on illiquid-long term investments, sometimes high in complexity, that trade liquidity and high volatility for (supposed) long-term outperformance.

We’ve heard the case for complexity. How about the other side of the argument?

The Case for… Doing Nothing

Most endowments and pension funds in the US follow a model similar to the aforementioned Yale Model: Large investment teams consisting of veteran investors, making active bets on managers, geographies and industries with the goal of outperforming the market over the long-term. Interestingly, that idea is being upstaged by one of their own. Steve Edmundson, CIO of the Nevada Public Employees’ Retirement System (NPERS), chooses to (mostly) do nothing at all. 

(Edmundson was interviewed by the Wall Street Journal in one of my favorite pieces of financial journalism, ever. More recently, Edmundson was also interviewed for the Meg Faber Show podcast.)

NPERS, to the most part, goes against the ideas of the Yale Model and its search for complexity. Its capital of roughly 60 billion dollars (as of December 31, 2023) is to the most part invested in passive investments: For US stocks (41% of is target allocation), they are invested in the S&P. For international stocks (16% of its target allocation), they are invested in MSCI World ex-US. For US bonds (28% of the target allocation), they hold US treasuries. The only exceptions are Private Real Estate and Private Equity (12% target allocation), which they have outsourced to external managers.

And the results speak for themselves: Since inception, NPERS has outperformed the market return by 0,3% p.a., and has outperformed over 3-, 5- and 10-year periods. Compare that to CalPERS, the largest public pension fund in the US, which employs a large investment team and makes active investments in liquid and illiquid assets - yet lags its benchmark over a 20-year period and just barely outperformed over 10- and 30-year periods.

It’s interesting to see that large institutional investors suffer from the same level of “ego” that I personally see in affluent investors (and admittedly, sometimes myself): We have a top-notch team, we are smarter than other investors - we can generate alpha, we can outperform the market. But can they, really? Often, the numbers tell a different story.

Many affluent individuals that I talk to think that they need to invest differently from the average retail investor simply because they have more investable capital. After all, that level of investable capital is needed to access some asset classes in the first place, such as private equity or hedge funds - and the recent push by GPs into fundraising from affluent individuals (including frequent chart crimes in their pitches) don’t help either. But it’s especially in such a moment where I like to highlight the story of NPERS: It’s a massive pool of capital, run by a tiny investing team, that actively chose not to make active choices - and that is succeeding with that strategy.

So what’s the right way to go - complex or simple? Let me show you how I tackle the question.

Radically simple - unless it makes sense

When working with affluent individuals, I like to use the Aspirational Investor Framework, which divides an individual’s total wealth into three buckets. 

The Safety Bucket tends to be simple by nature, typically consisting of a personal residence, some cash, and some fixed income. But as we move to the other two buckets, things can quickly get much more complex: The Market Bucket can be as simple as an equity index fund, but can also include self-managed commercial real estate or venture capital funds. The Aspirational Bucket can go even further, with essentially no limits to the level of complexity for the investments held there.

And accordingly, clients wonder how complex their investments should be, and how much such investments make it necessary for them to be hands-on in their portfolios. After all, they see the financial appeal of more complex investments - either through first touchpoints through an angel investment, or of course, the dinner party stories of their fellow affluent investors.

Most affluent individuals that I work with made their money as entrepreneurs - meaning that they started, grew and operated a business until an eventual exit. Few of them are investors by training. But let’s say they make the transition from entrepreneur to investor. They build the ability to pick the right complex investments - and reasonably outperform. But is that time spent on financial outperformance worth it? Very often, the answer is no: Yes, they might outperform the market by one, two, three percent - but that’s not where their strength lies. It’s in their abilities as an entrepreneur, as an operator. And especially if they are thinking of starting or advising another business, their time is much-better spent in their fields of professional expertise where they also have a significant return on their time through “sweat equity” and often little capital they need to invest themselves. 

Using our prior descriptions, it's in those asymmetric investments that they should spend their time - in particular those that lay in their field of prior entrepreneurial expertise. It’s the investments in the Aspirational Bucket which might fail, but if they succeed, might bring an affluent investor’s wealth to a level that traditional investments likely can not achieve over reasonable time periods.

Or how I like to describe the matter to my clients: It doesn’t matter if your equity portfolio makes 6, 7 or 8 percent - you’ll likely see life-changing returns through your entrepreneurial efforts, entirely independent from your investment portfolio.

And that also brings us back the balance of simplicity and complexity. For clients that trust my argumentation, and that look to build their next big business, their goal should be a radical reduction in complexity in their investment portfolio:

If you want to invest in fixed income and public equities, invest in index funds and ETFs, or if you are a believer in active management, find someone that you trust, and whose job it is to do nothing but invest in what you are looking for. Don’t try to make half-informed, active investing choices that bring you headaches when they go wrong.

If you want to invest in private equity or real estate, find a trusted fund or partner that you can commit to on an ongoing basis - or find a good fund of funds that allows you to buy into the long-term average return of the respective asset class.

If you want to do venture capital or other direct bets, be conscious of your time investment - or ideally flag that your investment is purely financial, and that you might not be the investor coach they are looking for.

And in doing all of that, optimize for your cost structure. It’s actually Steve Edmundson of NPERS who describes the matter perfectly in his recent podcast appearance: We can’t influence market returns, but we can influence costs. And the lower the costs, the better.

And if you do everything right, your investment portfolio should cause you little work yet generate market-level returns, perhaps even slightly above that - all while allowing you to invest your time into the projects that matter. Your next business, a venture bet.

Or maybe just in some free time to spend with your loved ones.

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