The Globe and Mail, Report on Business
Published December 15, 2006

I've been in the investment business since 1983 and I find that with each passing year simplicity becomes more and more appealing. And I don't think I'm alone; it's my observation that the more experienced investors become, the more they gravitate back to the basics.

Unfortunately, the current market for investment products is steaming ahead in the opposite direction. There are new investment products coming at us daily - each one more complicated and with more features than the previous one. Increasingly, I feel like the guy who goes into Baskin Robbins and orders vanilla in a cup.

As we go through this product proliferation, it's important to know that no matter what product you pick, it all comes back to stocks and bonds. The returns from all these fancy packages and flavours of the month are determined by how stocks and bonds perform.

While expanding on this theme, I'm going to focus this column on stocks, though in most cases my comments would also apply to other long-term assets, such as bonds and real estate.

If all roads lead back to stocks, let's first look at the most basic way an investor can gain exposure to this asset class, which would be to buy a portfolio of stocks, either individually or through a mutual fund, and hold it for a long time. By taking ownership stakes in a variety of corporations, the investor can expect to generate higher returns (in the form of dividends and capital appreciation) than would be available if he or she acted as a lender to these firms (i.e., bought bonds). Along with the higher returns, however, will come unpredictable gyrations in the portfolio value and, perhaps, some sleepless nights.

As we move away from that basic model, we have to remember that none of the possible derivations come with a silver bullet. In other words, the packagers that construct these products - investment bankers and marketing departments mostly - have not found a new source of investment return. Indeed, developing innovative packaging costs money and involves more people, invariably leading to lower long-term returns.

So while these new products don't add to returns, they do help to customize the kind of returns the client will receive. They effectively change the mix between reward, risk and income. Tradeoffs are made so one feature can be enhanced at the cost of another becoming less attractive.

For example, a basic equity portfolio has certain return, risk and income characteristics. By comparison, a principal-protected note (PPN) cuts off some of the return from owning stocks in exchange for eliminating the risk of losing money. Some closed-end or hedge funds use financial leverage to boost returns, with the tradeoff being that volatility and potential downside risk increase as well. Funds attempting to generate a regular income that is above the risk-free rate (i.e., government bonds) are sacrificing capital appreciation and, in some cases, inflation protection. These products, and a gazillion others, all make tradeoffs between those three variables.

There are consequences to all of this. In addition to raising the client's cost of investing, all of this dial-turning also serves to change the person or team making the added-value decisions. In the basic equity mutual fund, a professional stock picker is making the decisions. With the addition of every new feature, however, the stock picker's impact on product returns is diminished.

Investment bankers start to play a role in how the product is constructed. Strategists and economists get involved when sector rotation, market timing or leverage comes into play. And for products that have a structural bias (i.e., some of the new exchange-traded funds have a permanent tilt toward a particular strategy), statisticians or academics might even be involved.

I think this an important consequence because I'm a firm believer that bottom-up stock pickers have the best chance of adding value over the long haul. It's more difficult to consistently add value through market timing, currency hedging, derivative strategies and data mining. I don't expect that everyone is going to agree with me on this point. Nonetheless, it's important that buyers are aware of where the added value is supposed to be coming from.

And it's hard to dispute the other things that buyers need to know.

First and foremost, there is no silver bullet. Wraps, PPNs, index-lined notes and other structured products haven't magically found new sources of investment returns.

Second, these products are an expensive way to invest, so you'd better feel strongly about the features you're getting.

Third, the complexity of your portfolio will increase and the transparency of how it works will decrease. As to transparency, I'm reminded of the drinking and driving ad in which the view through the camera grows increasingly fuzzy as beer glasses are added to the bar table. Each additional enhancement or twist is the equivalent of another beer glass.

Structured and managed products are designed to make life simpler for the investor, but I think the opposite it true. In my opinion, there is a greater likelihood that the buyers will fail to get what they needed, what they wanted and/or what they thought they were getting.

In the meantime, I'll stick to vanilla.