Simple Is Usually Better

IndexUniverse posted a blurb about a new FTSE index that will weight "emerging market" countries by investor fund flows subject to some sort of market cap weighting process. I take this to mean that Slovakia could never be 18% of the index like China is of the EEM fund but maybe Slovakia could range from something like 0-4% based on fund flows as a made up example.

It is unlikely that this index is being created purely as an academic exercise. No doubt they hope to see someone create an investable product like an ETF. These markets have been hot so it is plausible that someone would think there would be demand for such a product.

Strategic funds like this are a mixed bag. Some turn out to be pretty good and some stink and there is no way to know ahead of time whether a particular product will be the former or the latter as all of them backtest very well (there would be no fund if the backtest stunk).

There are a lot of strategic funds out there with more on the way ranging from broad exposures that are intended to beat the market like 130/30 funds to what I'll call narrow effect funds like some of the hedge fund strategy replicators from IndexIQ.

While it is impossible to know what people perceive as they read my posts about portfolio construction (some will think it is simple while some might think it complex) but the vast majority of what we own are simple tools, either an individual stock or plain vanilla ETF, to capture just about every desired exposure we have.

During the panel that I moderated the other day at the Superbowl Of Indexing, Scott Burns (panelist from Morningstar) asked me "well, you actually use these what do you do?" So I gave the example of Colombia which is a country we do not own. I said, paraphrasing, being top down that once I decided I wanted in, I would then try to figure the best way in. That might be the Global X Colombia ETF (GXG), Ecopertrol (EC) or the big cement company. If I had thought it was appropriate to elaborate I would have noted GXG's very heavy weighting in financials which would have required a pretty good study of whether I want Colombian financials or not.

The example above would boil down to a plain vanilla ETF versus a couple of stocks. Between the two I would say a stock is a simpler product than an ETF even if would require more work. With a strategically complicated product like a 130/30 or the above fund flow index you run the risk of the strategy not working maybe because of something like things that worked in the last five years not working in the next five years or maybe poor implementation.

A non plain vanilla product, maybe it owns swaps, futures or some other derivatives, runs the risk of malfunctioning or otherwise not doing what investors "expect" during some sort of extreme market event for reasons that may or may not be understandable. Lacking of understanding is something that can lead to panicked reactions at the wrong time. As I said during the flash crash (literally) an individual stock does not go from $50 to a penny in 20 minutes on no news. This sort of thing is a malfunction bigger than any one stock and will be corrected soon enough. This statement is potentially less true with some complex product relying on levered counter parties to function.