Morningstar - Q2 2022 - 10

Dispatches
The Four Horsemen
of Investing
Corral these risks to
improve the odds
of investor success.
PHILLIPS CURVE
Don Phillips
Complexity, concentration, leverage, and
illiquidity are the four horsemen of the investor
apocalypse, perennial threats that wreak havoc on
portfolios and undermine even the best-laid
plans of diligent investors and their advisors.
Unfortunately, these same four horsemen are also
profit generators for Wall Street, thus creating
a continual tug of war in investment management
between what's advantageous for the provider
and what's beneficial for the investor.
Consider Jack Bogle's beloved traditional index
fund. This investment averts the four horsemen
at every turn. It is simple, diversified, unleveraged,
and highly liquid. In contrast, the typical hedge
fund is complex, concentrated, often leveraged,
and generally illiquid. The differences are reflected
in their pricing. The perceived sophistication
in the hedge fund allows its purveyors to charge
higher prices, while the simplicity of the index fund
commoditizes the offering and demands a low
price. That's why cost is such an effective firststage
screen in selecting investments: Not only do
lower-cost investments save money, but they
keep the four horsemen at bay, thus upping the
odds of investor success.
The four horsemen provide a useful rubric
for evaluating an investment's potential to serve
investors well. Given this backdrop, it was
dismaying to read the agenda of a recent
high-level gathering of asset managers. The topics
included alternative investments, the assetgathering
success of a concentrated active mutual
fund, and the emergence of a new generation
10
Morningstar Q2 2022
of brokerage firm that makes trading stocks seem
like a game but still carries the traditional
brokerage practice of offering margin accounts.
Each of these activities summons one or
more of the horsemen.
Alternative investing was the central topic. The
theoretical benefits of alternatives entice.
Something that zigs while the rest of a portfolio
zags could protect investors in tough times.
But after more than two decades of experimentation
with alternatives in the retail mutual
fund space, there is little evidence that investors
have benefited. Alternatives get promoted not
at peaks where they might protect from declines,
but at troughs where they limit participation
in rebounds. As former Clipper CFIMX manager
Jim Gipson noted, the popularity of an
investment idea approaches its zenith as its utility
approaches its nadir. Such has been the case
with retail alternatives, where all four horsemen
have at times undermined results. Even
professionally managed target-date funds have
failed to demonstrate how alternative
investments can be deployed in a portfolio to
provide tangible aftercost benefits for investors.
That won't stop Wall Street from trying.
The jaw-drop slide of the conference compared
the market capitalization of Blackstone BX,
which specializes in alternative investments, with
BlackRock BLK, a dominant player in more
traditional and, especially, indexed funds. The
big takeaway was that even though Blackstone
manages a smaller amount of client assets,
it is accorded a higher market capitalization. The
lesson is clear: The easier path to success isn't
playing the scale game of managing lowcost,
unleveraged, broadly diversified investment
options, but through launching pricier, more
complex fare.
The four horsemen don't only ride in alternatives.
A concentrated thematic investment fund was
a further topic of conversation at the conference.
Personally, I admire managers who bet big on their
best ideas, but we've seen this show before and
know by now that such funds rarely produce
good investor outcomes. Consider the Janus funds
of the late 1990s that brought in huge sums (aided
by high-profile advertising) at the peak of the
tech bubble. Or Ken Heebner's very concentrated
CGM funds that earned him cover-story praise
from a glossy business magazine in June 2008 as
America's Hottest Investor, just before the financial
crisis hit. For the full calendar year of 2008,
America's hottest investor singed client assets to
the tune of a 48% loss in his CGM Focus CGMFX.
Concentration brings higher highs, but it also
brings out the worst in investor behavior, as many
are tempted to buy at the peak. Until Wall
Street finds a way to help investors better harness
these funds, they will be better bets for their
issuers than their buyers.
Another hot topic was a retail brokerage where
investors have been chasing meme stocks.
I'm all for greater access to markets, but I shudder
to think of the real-world consequences of
frequent trading in stocks on which you've done
little to no research. The tax-filing implications
alone are a complexity headache. A bigger
concern, one not unique to any particular
brokerage, is the widespread use of leverage. If
a Yahoo Finance-Harris poll is to be believed-and
the results seem stretched to me-43% of retail
investors leverage their investments through
options or margin accounts. This will not end well.
Public mutual funds have a rotten record using
leverage-and they are the pros. Retail investors
are unlikely to fare better. While much has
been made of the liquidity issue over GameStop
GME when trading was temporarily curtailed,
the horsemen of concentration, tax complexity, and
leverage are equally ominous.
The four horsemen also loom large in this issue's
Spotlight topic, private equity. Complexity,
concentration, leverage, and illiquidity are all in
play here. While there's much theoretical appeal
to giving smaller investors access to private
markets, the tug of war to determine how much of
these benefits will flow to investors after costs has
yet to play out. If special-purpose acquisition
companies offer foreshadowing, small investors'
odds look grim. Private equity has the qualities
that make it something Wall Street will be eager to
sell; it will take great skill to make it something
wise investors should buy. K
Don Phillips is a managing director at Morningstar. He is a
member of the editorial board of Morningstar magazine.
https://www.morningstar.com/funds/xnas/cgmfx/quote https://www.morningstar.com/authors/286/don-phillips https://www.morningstar.com/funds/xnas/cfimx/quote https://www.morningstar.com/stocks/xnys/bx/quote https://www.morningstar.com/stocks/xnys/gme/quote https://www.morningstar.com/stocks/xnys/blk/quote https://www.morningstar.com/stocks/xnys/gme/quote https://www.morningstar.com/authors/286/don-phillips
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