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“INVESTING IS SIMPLE,” observed HumbleDollar’s editor Jonathan Clements. “To be sure, you can make it ludicrously complicated.” And, indeed, Wall Street does just that.
According to a recent analysis by Bloomberg, the fund industry rolled out more than 640 new exchange-traded funds (ETFs) in the first half of this year—an average of more than three a day. There are now more ETFs in the U.S. than there are stocks (4,300 vs. 4,200). On top of that, private funds continue to launch at a fast clip.
How should investors respond to all of this innovation? I’d steer clear. While some of these new funds may be worthwhile, many are, in my view, witch’s brews that are unlikely to be useful.
Why? The standard reasons are well known. For starters, a large number of these new funds are actively-managed and, on average, actively-managed funds are more expensive than their index-based peers. As the late Jack Bogle used to say, when it comes to investments, “you get what you don’t pay for.” As a result, actively-managed funds, on average, have consistently underperformed their index-based peers. Active funds also tend to be more tax-inefficient than index funds.
There’s also Lindy’s law, which tells us that we should approach new investments cautiously—not because there’s an inherent virtue in moving slowly, but because, when it comes to investments, it’s important to see how they perform through multiple market cycles.
But those aren’t the only reasons I suggest avoiding these new funds. Below are additional considerations.
Complicated investments are often hard to categorize, and that makes them less-than-ideal from a risk perspective. Consider this pitch for a new fund: “The strategy actively rotates between equities, Treasuries, and cash depending on market volatility and trend signals. It’s fully rules-based, unemotional, and adaptable in real time.”
If you wanted to establish an asset allocation for your portfolio, with specific percentages in stocks and in bonds, this fund would be of no help. That’s a problem, in my view, because research has found asset allocation to be the most important driver of portfolio risk.
Black-box funds like this also make it difficult to estimate what level of returns they might deliver. That’s hard enough with traditional funds. But overly engineered funds make it that much harder. Consider this fund description, which arrived in my inbox this summer: “[Our fund] equips advisors with tactical exit strategies and patented indicators designed to limit downside and preserve growth.”
Or consider this pitch: “Our new tactical ETF…takes a dynamic approach to asset allocation, designed to help protect on the downside and participate when markets turn.” These descriptions sound sophisticated, but they provide investors with little idea of what they can expect. Peter Lynch, the retired manager of the Fidelity Magellan Fund, once offered this advice: “Never invest in any idea you can’t illustrate with a crayon.” That was as true then as it is now.
To the extent that funds are pursuing so-called tactical strategies, that should be of particular concern. According to a study by Morningstar, tactical funds are among the most risky out there. This is how Morningstar summed up the performance of this category: “They Came. They Saw. They Incinerated Half Their Funds’ Potential Returns.”
Another unwelcome trend on Wall Street is the use of what are known as “interval” funds. They’re designed to provide a bridge of sorts between private and public funds. As the name suggests, these funds allow investors to withdraw money only at defined intervals—monthly, quarterly or sometimes semiannually. That would be inconvenient enough, but redemptions are also capped, typically at 5% or 10% of the fund’s shares outstanding, so investors may not always be able to withdraw as much as they’d like if demand is high.
A related trend: Investment marketers are creating versions of the same sorts of “alternative” funds that have been popular with college endowments. This has always been a problem because individual investors typically can’t get into the same top-tier funds as big universities. Instead, what tends to be available are pale copies of what these big institutions are able to invest in.
Worse yet, recent evidence suggests that even those top-tier funds have seen returns deteriorating. It turns out that the boom in private equity was fueled in large part by the long-term trend toward lower interest rates. But with rates now higher, buyout firms have been having a harder time generating the same types of profits as before.
In an interview, a retired member of Yale’s endowment management team explained, “Just because something has worked for a particular set of institutions over some period of time, it’s not a guarantee of future success.” This is good advice.
Because the market for alternative investment funds is so challenging, these funds fail quite frequently. According to recent data, over the past 10 years, 75% of alternative funds have closed down. That can be a problem because fund closures can generate taxable gains, and this occurs much more frequently with actively-managed funds than with simple index funds.
Fundamentally, the challenge with all of these new funds is that no one has a magic wand. Especially when there are more funds than there are stocks, there just aren’t that many new ways to combine investments into something new and better than what already exists. Despite that, Wall Street continues to roll out new offerings every day.
How should you respond? Morningstar’s Jeffrey Ptak puts it best: “The more rhapsodic the sales pitch, the more you should plug your ears.”
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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