2 + 2 = 4 (or does it?) 

I’m increasingly challenged by how advisers address complexity.  Google the question “does 2 + 2 always = 4” and you might be surprised at the results.  From discussions about which type of scale you use, what you are measuring, what sort of number system you are using, to cultural constructs and other matters like rounding or other simplifications, you will be enlightened. 

But if you ask someone if 2 + 2 = 4 it is unlikely that they will disagree.  But it does illustrate nicely that something we may take as given, usually because no-one ever taught us that there was another way of thinking about things, should occasionally be questioned.

So, in another thought prompted by the Vanguard discussions about ETFs, I need to confess that I dislike synthetic ETFs.  Now, I know well that while the FCA and many others consider any type of derivative, however, employed, to be the spawn of the devil, unfeasibly high risk and to be avoided like the plague, anyone who works as a professional investor frequently considers using a whole range of derivative structures to reduce risk and / or volatility in a holding, and asset class, or a portfolio.

Even the simple hedging that many conventional fund managers will employ to take currency risk out of their portfolios is a derivative.  So do we systematically avoid any portfolio which hedges currency risk?  Do we accept currency risk alongside all the other investment risks?  Or do we decide to only invest in sterling?  And if I dislike derivatives in ETFs on what logic would I accept them in a hedged OEIC?

As far as ETFs are concerned I have in the past taken the view that a passive investment should be in a mainstream index, fully replicated, and backed with the assets in which you are investing.  But, as someone was kind enough to point out, the exclusion of synthetic ETFs means the risk of greater exposure to tracking error (you could track the index precisely if you bought the derivative to achieve precisely that outcome) and you could access inaccessible markets (China?) or illiquid ones (Brazil?) without the market participant and liquidity risks which would apply to other (allegedly) more transparent and straightforward alternatives – oops – options – oops – choices!!

My conclusion : Doris Lessing, author and Nobel prize winner got it right when she said “Things are not quite so simple always as black and white.”  All we have to do now is learn for ourselves, and then teach our clients, that sometimes things, especially in our world, aren’t as simple as 2 + 2 = 4.
Gill Cardy, 13/06/2014