One of the major investment fallacies around is that some investors believe or being told that because they are "sophisticated" they need sophisticated investments which will yield higher returns than those available to ordinary souls. Fortunately, for us -the ordinary investors - this is far removed from reality. Mark T. Hebner, President, Index Funds Advisors, explains this in his weekly column:
In the recent controversy swirling around Goldman Sachs, we have had the good fortune to be introduced to many charming Wall Street expressions such as "ripping the client's face off" or "blowing up the client". However, one term that has kept showing up like a bad penny (or a defaulted subprime mortgage) is "sophisticated investors". Specifically, Goldman has countered the SEC's charges of fraud with the claim that all the poor saps on the wrong side of the synthetic CDO trade were among the world's most sophisticated investors, and thus deserve neither sympathy nor recompense. The merits of Goldman's arguments will be left to the courts to decide. Our purpose here is to take a deeper look into the general application of the term "sophisticated investor".
It is IFA's position that the term "sophisticated investor" carries no value and is best expunged from our vocabulary. There are good investors who diversify both within and among asset classes, control their costs, and keep constant vigilance over their self-destructive behavioral tendencies. Investors who fail to do these things can be classified as poor investors (pardon the double entendre). It has nothing to do with one's level of investable assets. While it may be tempting to apply the "sophisticated investor" label to certain institutions such as Goldman Sachs which had not a single day of trading losses in the first quarter of 2010, we would be remiss not to point out that the bulk of these trading profits derived from their ability to borrow from the government (i.e., taxpayers) at zero and collect a spread on lending back to Uncle Sam, all the while using leverage to magnify their gains.
Regarding Goldman's "recommended top trades for 2010" for its ultra-sophisticated clients, a recent article on Bloomberg.com showed that seven of the nine trades have been money losers so far in 2010. Some of the trades, such as buying the Polish Zloty while shorting the Japanese Yen almost sound a bit goofy. The spokeswoman for Goldman Sachs, Gia Moron (You can't make this stuff up!), declined to comment. Considering that the clients of Goldman Sachs are receiving investment ideas from a firm that does not owe them a fiduciary duty the term "sophisticated" seems highly misappropriated.
When we hear that someone is labeled as a "sophisticated investor", two possible images come to mind. The first one is of the high net worth individual who has access to exotic investments that are off limits to the most investors. Chief among these would be hedge funds. It is important to bear in mind that hedge funds are not required to report their performance, so the overall performance of various hedge fund categories reported by various databases is likely to be heavily upward biased. If you are a client of a major Wall Street firm and your broker tells you that you are a sophisticated (or qualified) investor, IFA's best advice is to turn around and run for the hills. This term is often used as a license to sell you a complex product with high fees and hidden risks such as leverage. The application of these terms to investors has often led to a dilution of fiduciary duty, which even if it is not explicitly contractual, is normally expected by clients. Just as Goldman and the other Wall Street sharpies regarded their trading partners (e.g., AIG) as sheep waiting to be slaughtered, clients of these firms have no reason to expect better treatment.
The second image of the sophisticated investor is the rocket scientist from MIT employed at Goldman Sachs who designs exotic derivative instruments that the rest of us can barely begin to comprehend. As with the wealthy hedge fund investor, risk and return are inseparable, and no application of brainpower will ever result in cheating risk. The market owes nobody a higher return merely because they are smarter than most of its participants. Every mathematical model in finance is built on assumptions, and 2008 taught us what happens when one of these assumptions turns out to be incorrect.
Other strategies that we associate with sophisticated investors are short-selling and buying on margin. However, thanks to companies like Profunds and Direxion, anybody, regardless of their level of "sophistication", can take a double/triple leveraged/short position in almost every index under the sun. A question worth asking is whether having access to these strategies is more likely to enhance or destroy wealth. The fact of the matter is that even if someone can successfully predict the return of an index over the next 1 to 12 months (which nobody can do except by luck alone), he will not be able to capitalize on his investment acumen using these instruments.
When it comes to sophisticated investors, it is truly a case of the emperor having no clothes, so perhaps the world would be a better place if we limited our use of the word "sophisticated" to describe advanced tastes such as art, music, or literature.
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