Five things institutional investors understand that you don’t
Dean Smith
Chief Strategist | FolioBeyond
6 min read
Institutional investors are responsible for managing trillions of dollars in assets. This includes money invested in mutual funds, pension funds, endowments, insurance company portfolios, bank and trust accounts, and more. And while there has been a secular shift towards self-directed retail investments in recent decades, via 401Ks and otherwise, professional managers still control the bulk of financial assets.
It is also true that most individual investors do a much worse job of managing their investments than a typical professional manager does. Why is that? There are five primary reasons. If you understand these and change your habits accordingly, you can probably improve your long term investment performance — perhaps significantly.
Note that for this discussion we are ignoring high flying investors like hedge fund managers and high-frequency traders. Most of them don’t perform well enough to earn the fees they charge, but that is a conversation for another day. For now, we are focusing on longer-term investment strategies that are aiming to achieve long term goals.
Number 1: Beating the market by a significant amount, consistently over time, is essentially impossible.
I realize that many readers will instinctively resist this, but it is objectively and undeniably true. There are exceptions to every rule (fine, Warren Buffet, although even he has stumbled lately) but smart institutional investors know that trying to crush the market is a fool’s game. There are simply too many highly motivated participants, all with access to the same information to make it possible for anyone to win big, repeatedly over a period of years.
Academics refer to this as the “Efficient Market Hypothesis,” and there is no other financial concept that has been proven so definitively, over and over again. Researchers and practitioners get into arcane discussions of “strong forms” vs. “weak forms” of the EMH, but for the rest of us, we need to just accept it and move on — to the second point that institutional investors understand.
Number 2: The amount of risk you take is more important than the return you target.
So, if they can’t actually beat the market, what is it that the pros do all day? In short, they manage their risk. Oddly enough, it turns out that it is easier to measure and manage the amount of risk in a portfolio than it is to achieve some market-beating target. Note, I said “easier,” not easy. Let me explain.
Institutional investors, unlike many retail investors, tend to look at their portfolios as a whole, rather than as a set of discrete investments. So rather than simply buying things they believe will go up in value, they first think about each prospective investment’s place in their portfolio relative to all the things they already own. This is because of a statistical concept called “correlation,” which measures the extent to which two or more investments tend to move in the same direction, or for one to “zig” while another “zags.” In addition, each potential investment has an intrinsic level of riskiness, which can be measured in any number of ways (price volatility, liquidity, credit risk, etc.). When institutional investors are assembling and managing their portfolios, they spend most of their time trying to determine how much risk they have and whether that is consistent with their view of current conditions.
They do this because they understand that actually losing money outright is much worse than falling short of a target return. By managing their risk, they can reduce the likelihood of an outright loss, although it can never be eliminated entirely, of course. This brings us to the third thing the big players know, that smaller folks often miss.
Number 3: Maintaining diversification requires attention and diligence.
Diversification is often described as “don’t put all your eggs in one basket,” and is one of the main ways to manage risk. But the eggs are forever moving around in that basket, and some are growing while others are shrinking. For instance, large cap technology stocks have been soaring for several years. A portfolio that started with a reasonable share of its investments in big tech might now be dangerously overweight if no rebalancing has occurred. And so, as painful as it might be to sell a high-flyer, investment discipline requires making rebalancing decisions at regular intervals to avoid over-concentrations in any sector or asset class.
There are all sorts of homespun aphorisms one hears to counter this practice. “Let your winners run, and cut your losses” is a frequently-heard expression. But the reality, as most professionals understand, is that the future matters more than the past. How a portfolio came to be overweight or underweight is history. The question to be considered today is whether the portfolio one owns today is positioned correctly, i.e. appropriately diversified, going forward. This is something professional investors do instinctively, and individuals would do well to emulate. This leads to the fourth observation.
Number 4: Ignore the noise and maintain your discipline.
This is sometimes the hardest thing for any investor, large or small to do. When there is a major news story, or when the market makes a big move up or down, there is a strong and natural human urge to do “something” in response. In the vast, vast majority of cases that urge should be resisted.
It is for this reason that institutional investors will generally have an “investment committee.” This committee will establish the strategies and policies for the portfolio, and those are generally invariant to short terms events and market swings. Retail investors should aim to be an investment committee of one, or perhaps two if you have a partner with whom you are managing your investments.
If the premise underlying one’s investment strategy was well-founded, it is exceedingly unlikely to be altered by the noise or news of current events and market movements. Stick to your discipline and take advantage of opportunities that are consistent with that discipline when the market presents them. Most of the time, however, the best course of action is to do nothing. Which leads to the final point.
Number 5: Fees and expenses will eat you alive.
Institutional investors are generally satisfied if they can manage to earn an extra 1–2% per year through their active management process. (Most retail investors ought to feel the same, but seldom do.) One way to help reach that goal is to be laser-focused on fees and expenses. This includes explicit fees paid to brokers and other third parties, but also the hidden expenses that arise from overly-active trading in response to short-term swings in the market discussed above. Now that retail brokerage commissions are essentially zero, some retail investors may conclude that there is no cost to a more active trading posture. This is incorrect.
For one thing, one still incurs a bid-ask spread when trading. More importantly, there is slippage that occurs when markets are moving quickly, and you are just a step or two slower than the professional traders. The reality is you will likely be many steps slower, and your execution — whether you are buying or selling — will likely be much worse than you think, if you were to analyze it as ruthlessly as institutional traders do. Institutional investors spend enormous resources on trade execution because they understand how careless trading can produce a huge drag on their return.
Conclusion
The actual practice of managing vast portfolios worth billions of dollars is obviously not something that retail investors can duplicate. This has also been a very high-level, simplified description of how the game is played at the institutional level. However, you can improve your long-term investment performance if you “think like” the big guys and avoid these five simple mistakes they work hard not to make.
Reference:
https://medium.com/@dsmith6302/five-things-institutional-investors-understand-that-you-dont-ac3f722de61c
