Complex Financial Products — Sophistication or Job Security?

Simplicity is the ultimate sophistication -– Leonardo da Vinci

We’ve all seen or heard about the guy at work who makes his job seem more complicated than it really is so that it’s harder to lay him off. Wall Street product manufacturers are wizards at this. They invent and re-invent complex financial products like variable annuities, structured products, or principal protection funds, and market them as “sophisticated” products that give you an edge over other ‘less-informed’ investors. But there is often a price to pay for that ‘sophistication’. 

A little history

In the 1990s, as mutual funds were becoming more prevalent because their fees (though high) were lower than the cost of your typical brokerage account, Wall Street came up with Separately Managed Accounts (SMAs), also known as “Wrap Accounts” because one single fee wrapped around the whole account and covered everything. The allure of wrap accounts was that you could have the same guy who ran popular mutual funds manage your brokerage account. And by owning the individual stocks instead of the mutual fund, you could hand-pick your capital gains or harvest your losses, for greater tax efficiency.

In practice, they were just more expensive. Few people took advantage of the ability to pick through the portfolio to actively seek out the losses. Also, it was harder to properly diversify your portfolio, since with a wrap account, each kind of asset requires a separate brokerage account. The sheer volume of monthly statements, trade confirmations, corporate reports, proxy notices, and annual tax reports could be measured in pounds! And since your CPA would have to wade through all that paper to prepare your taxes, your tax preparation fees can be higher as well.  

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New twists on the old theme

Wall Street is at it again with a twist on this old framework called “Direct Indexing.” Since many investors have ditched expensive managed mutual funds and brokerage accounts in favor of cheap index mutual funds and exchange traded (indexed) funds (ETFs), Wall Street has come up with direct indexing, which is basically a Wrap account but this time tracking an index instead of managed by a fund manager. The pitch? Track an index but own the individual stocks so you can harvest the losses when they occur or possibly exclude industries you don’t like (such as tobacco or oil).

The catch? To name a few:

  • The fees may be much higher than index mutual funds, causing your performance to suffer.
  • Harvesting the losses isn’t as efficient as it sounds (if not done correctly, you can accidentally cause dis-allowed losses and increased taxes.)
  • Having all those individual securities in each account makes things cumbersome and hard to decipher, and it creates even more work for your CPA and your mail carrier.
  • One account won’t give you proper diversification so you may need several of these accounts.

Why do brokers like these accounts? They can charge higher fees for the more complicated product and offer the allure of greater tax efficiency. Another bonus for the broker who sells you this concept is that after you own one of these accounts for a few years, almost all of the stocks will have built-in capital gains, making them more expensive to sell and a LOT harder to change your investment strategy or switch to another advisor who doesn’t use the same products.


Invest $100K the Right Way

At some point, you may find yourself with $100,000 in the bank and questions on how to invest it.

person investing on a phone

In the long run, on average, index mutual funds outperform managed funds largely because their fees are lower. Because of their lower costs, index mutual funds and ETFs will likely outperform these accounts, too.

Confusion is the enemy of clarity

A complaint we often hear from people looking to change financial advisors is that their investments are confusing. Often people must wade through a mishmash of different entities, accounts and company names to arrive at the investments held in their portfolio. With complexity comes confusion. With complexity often comes steep costs. And with complexity comes dependence on financial professionals who ‘understand’ complex products. Perhaps the most dangerous thing about complexity is that it can distract you from the most important things- evaluating your investment plan, measuring your progress toward goals, and making changes where necessary.

At Blankinship & Foster, we believe that investment portfolios should be designed with high quality, low cost and transparent investments, and managed with a prudent and consistent approach to control risk and minimize costs. This straight-forward approach may not seem very “sophisticated,” but it will make things clearer and easier to evaluate, so you can be confident you are on the right track even in the face of market ups and downs.

Disclosure: The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice, and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites.

About Rick Brooks

Rick Brooks, CFA®, CFP® is a partner of Blankinship & Foster LLC and is the firm’s Chief Investment Officer. He is a lead advisor, counseling clients on all aspects of personal financial management. Rick serves on several boards. He is the Chairman of the Board of Girl Scouts San Diego, and also chairs the San Diego Foundation’s Professional Advisor Council. Rick and his family live in Mission Hills. Rick enjoys spending time with his family, theater, cooking, skiing, gaming and reading.

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