Why You Shouldn’t Emulate Institutional Investors

In 1994 Peter Lynch stood in front of the national press club, attempting to explain ‘good investing’ to the individual investor. And of course, who better to listen to than Peter Lynch. He achieved a compounded average return of 29.2% between 1977 and 1990:

I frankly think it’s a tragedy in America that the small investor has been convinced by the media, the print media, the radio and television media, that they don’t have a chance. The big institutions with all their computers and all their degrees and all their money have all the edges and it just isn’t true at all.

Strange coming from a fund manager. Lynch continues:

When this happens, when this occurs, people act accordingly. When they believe it, they buy stocks for a week. They buy options and they buy the Chile fund this week and next week it’s the Argentina fund. They get results proportionate to that kind of investing. That’s very bothersome. I think the public can do extremely well in the stock market on their own.

Yet it’s hard not to think of hedge funds or fund managers as the ‘smart’ money. Other investors have collectively intrusted them with millions, if not billions to manage. They have multiple degrees and years’ worth of experience. These institutional investors really are smart, make no mistake.

However in some respects, they have to face headwinds like size. And of course they’re all still human…I think, which means they also make mistakes.

OK, slow down. Size is a headwind? How?

Well the idea is based on liquidity. Imagine having $500 million to invest. Sounds pretty good right? Well, you probably won’t be able to use $500 million effectively in any stock outside of the All Ordinaries (largest 500 stocks).

At any one time, how many top 500 stocks will be mispriced? I’m sure you could find a few, but it’s a very limited universe of investment, hence it also limited your returns.

And the mistakes can happen to almost anyone. But for some reason institutional investors seem to make the most. One example, is their love of activity. It would be hard to find many funds, outside value funds that hold stocks for more than five years.

But this hyper activity is just a toxic habit rampant within the investment industry. Take a look at the graphs below:

US small cap value mutual funds  US small cap value mutual funds

Source: Marotta on Money

Both charts show the relationship between turnover rates and returns, for 407 mutual funds. The top chart is over a three year period and the bottom chart, is over a five year period.

As you can see, funds with the lowest turnover rates performed far better than the rest. The reason why, in my mind, comes down to two factors.

First, holding undervalued stocks for longer periods should theoretically, give them more time to appreciate. Second, fund managers who had lower turnover rates — those who traded less — likely made fewer mistakes.

So then why do institutional investors continue to jump in and out of investments? Well, imagine the following hypothetical.

I gave you $50,000 to invest. You could invest in whatever stocks you wanted, domestic or international. You could also choose not to invest at all, if you didn’t see any opportunities. But the catch is, I would review your returns each quarter. If you didn’t beat your benchmark, the S&P 500, then I would take $10,000 away from you.

With all this information, how would you invest?

Would you try to buy undervalued stocks that might take a year or more to appreciate? Or would you jump in and out of ‘hot’ stocks, trying to capture short term gains?

You’d probably lean towards the latter right? It seems like the better option to beat your benchmark for the quarter. Well, this is the situation many fund managers are in.

So maybe I’ve convinced you that institutional investors aren’t all their cracked up to be? However, that’s not saying you can’t learn anything from them. Remember at the start where I said these guys and gals were really smart. However you should always take their ideas, strategies and activities with a grain of salt.

Who knows, year-to-year you could outperform one of these high powered investors.

Regards,

Härje Ronngard,

Junior Analyst, Markets & Money

PS: Interest rates will likely be low for the foreseeable future. While that’s not great news for your savings rate, there is a chance to profit from very low rates. Find out more here.


Harje Ronngard is a Junior Analyst at Markets and Money. With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation. It’s not good enough to be right on average when it comes to investing. The market is volatile and it only takes one bad day to ruin your portfolio. You don’t want to end up like the six foot man that drowned in the river that was five foot deep on average. It’s why Harje is constantly reminding investors of their downside risk here at Markets and Money. He does so by simply asking just two questions.  What is it worth? And how much does it cost? These two questions alone open up a world of investment opportunities which Harje shares with Markets and Money readers. Right now Harje is focused on managing research and investments over at the Legacy Portfolio. An investment publication designed to significantly grow investor’s wealth over time with deeply undervalued businesses. Harje also contributes his insights in Total Income, headed by income specialist Matt Hibbard. Harje loves cash-rich businesses, so he feels right at home amongst Matt’s high yielding income plays.


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