Complexity Adds to Cost and Risk

One of the greatest advantages of a passive investment strategy is its simplicity. With a passive approach, you can focus on capturing market returns without needing to monitor and trade constantly. Over time, an appropriately diversified portfolio aligned with broad market returns offers a high probability of achieving the kind of outcomes most investors seek.

Index funds and passively managed exchange traded funds embody this simplicity. They are transparent, low-cost, and straightforward. In contrast, when you buy into an actively managed fund, you never fully know what you’re getting. Active equity funds, for example, often include some allocation to bonds or cash and have high portfolio turnover, making it difficult for investors to track and understand what they actually own.

Complexity Is on the Rise in Active Management, and That’s a Problem

As it becomes increasingly difficult for active managers to outperform simple indices, they are adding complexity to their strategies to differentiate themselves — often at the expense of investors. Many are turning to sophisticated, high-risk tactics such as:

Leverage
Borrowing funds to amplify potential returns, which increases the risk of greater losses in downturns.

Short Selling
Betting on the decline of certain assets, which carries unlimited downside risk.

Illiquidity
Holding assets that cannot be easily converted to cash, making it harder for investors to access their capital when needed.

Hedge funds, private equity, and alternative real estate investments often use one or more of these tactics. These strategies are marketed as ways to protect against market downturns, but in practice, they often introduce more risk, not less. High-cost advisors may push these strategies to justify their fees, especially when high-quality bonds are yielding lower returns in the current environment.

Research Shows: Complexity Leads to Higher Costs and Lower Returns

A notable study from Queen’s University in Ontario, titled Use of Leverage, Short Sales, and Options by Mutual Funds, highlights the hidden costs of complexity in actively managed funds. Professors Paul Calluzzo, Fabio Moneta, and Selim Topaloglu analyzed U.S. domestic stock funds from 1999 to 2015, finding that a striking 62.6% of funds were authorized to use leverage, short sales, and options by the end of that period.

Their findings are a cautionary tale for investors. Funds that used these complex instruments underperformed simpler strategies, with a reduction in excess returns by 0.59% on average and an increase in expenses by 0.072%. These funds also exhibited higher unsystematic risk (risk that is specific to a company, industry, or sector) meaning that investors were exposed to greater unpredictability and volatility.

The study concluded that “the use of complex instruments is associated with outcomes that harm shareholders: lower returns, higher unsystematic risk, more negative skewness, greater kurtosis (a measure of extreme market fluctuations), and higher fees.” In short, mutual fund investors are generally better off with simplicity.

Why Are Active Managers Embracing Complexity?

Complex strategies are appealing to active managers for two main reasons. First, regulators permit them to use these high-risk tools, so they take advantage of that flexibility. Second, and perhaps more importantly, these managers are under intense pressure to differentiate themselves from low-cost index funds. In the words of investment expert Larry Swedroe, “The active world has to fight back to keep their share, and one way to do that is to add complexity. They need to say, ‘We have a story to tell, and you need to be a member of our secret club, which has all these superior instruments.’”

But for investors, complexity is rarely an advantage. Complexity obscures the real drivers of performance, making it harder to understand risks, fees, and underlying exposures. At the end of the day, these strategies often benefit fund managers and advisors more than the clients themselves.

WealthFactor’s Perspective: Simple, Evidence-Based Investing Wins

At WealthFactor, we believe that simplicity is the ultimate sophistication. We avoid actively managed funds and complex investment products because we know that their added layers of cost, risk, and opacity work against investors' best interests. Instead, our investment approach is rooted in a straightforward, evidence-based methodology designed to maximize returns through market exposure while minimizing costs.

Simplicity in investing isn’t about cutting corners; it’s about achieving your financial goals without the distraction of speculative or high-risk tactics. We focus on what works: broad market exposure, tax-efficient strategies, and disciplined, long-term investing. In a world that often rewards the flashy and complex, we’re here to remind you that when it comes to investing, less is truly more.