Insights from Marie Chandoha

Chief Executive Officer

Waiter! What does this mean?

April 2016

I recently went out to dinner at a hot new restaurant and found myself staring at the menu in a state of confusion. Just about every dish had a term I couldn’t identify. Salmagundi for starters? Does the average diner know the difference between "brunoise" and "mirepoix"? I don’t. And are we supposed to know whether a Maine periwinkle is a good periwinkle—or even what a periwinkle tastes like?

It's not just restaurants that have gone overboard with complexity. Who among us has ever read through a 10-page cell-phone bill? And, if we look at a watch advertisement in a magazine we’re not likely to see simple timepieces, but rather complicated machinery, with altimeters and barometers.

Of course, when it comes to industries that love complexity, finance may top the list. On Wall Street, it seems the thinking of many is the more complicated, the better.

But I’m not convinced that that’s true. I’ll take simplicity—something that I can intuitively and swiftly understand—instead of over-engineering and steeped complexity any day. And that’s true for menus, cell-phone bills, watches, and, of course, investing.

Wall Street and complexity

We don’t have to look far to find a slew of complex financial investments. There are structured instruments such as CDOs, CLOs and CDSs, for instance. And those are just some that start with the letter “C”. There’s a veritable alphabet soup of complicated financial securities such as ABS, MBS and RMBS. And there’s more. Since the start of 2014, nearly 200 “liquid alternatives” mutual funds have been launched1. These sophisticated strategies aim to package commodities, currencies and hedge-fund-like strategies into investments for the masses. I could go on—because the industry includes a vast array of such products.

Wall Street may be attracted to complex products because the more complicated they are the more they can charge for them. Who knows what the fees really are for some of Wall Street’s more opaque products? Many of the more complicated investments often lack real-time pricing, aren’t very liquid, and have a steep fee structure that isn’t always transparent. Some products may charge additional fees above and beyond typical management fees for buying, selling and managing the underlying securities. Some add features onto products, even features that might not be necessary, just to charge more. That’s the equivalent of adding an altimeter to a watch; charge more for the added feature although few of us ever really have to or want to know how far above sea level we are.

In investing, these unnecessary add-ons can add to the complexity of a product and that can get in the way of an investor’s best interest in
several ways.

In investing, these unnecessary add-ons can add to the complexity of a product and that can get in the way of an investor’s best interest in several ways. It can make them unaware of the products they are really buying. It can mask the level of risk they are assuming. It also can expose investors to overcharges. And it can make it harder for them to exit their positions easily and economically.

Ask for details

Of course, not all complex products are bad products—and some may even provide diversification or the opportunity to earn a decent return, thus warranting a place in an investor’s portfolio. As with all investments, if you find yourself considering such a product, you might ask three fundamental questions.

First, do you understand what you’re actually investing in? What is a CDO or a liquid alternatives fund and why does this investment deserve an allocation in your portfolio?

Second, is the potential return worth the risk? While all investments have some level of risk, it is important to recognize the downside and determine if it’s something you can stomach. While upside returns are always enticing, some investors don’t consider the risk level of certain investments before they jump in.

Finally: what are the fees? Make sure you know how much you’re paying for the complex product—on the way in, during the time you own it, and on the way out. After all, unknown or hidden fees can be corrosive to the best investments.

In a restaurant with a complex menu, you’d ask the waiter for some guidance—what does that periwinkle taste like, or what does mirepoix mean? Ask your financial consultant for details on your investments. In both instances, you don’t want to be left with the wrong taste in your mouth.

Marie Chandoha
President and CEO, Charles Schwab Investment Management

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