Retail Investors vs Institutional Money

I’ve worked in the Asset Management business for the last 6 years supporting both the Institutional Investment Management business and Retail Mutual Fund Business. The Institutional business includes pension plans for both the public and private sector, medium-sized insurance companies, university endowments and ultra high net worth families ($50+ million). The average institutional client has several hundred million dollars with an Asset Manager. The Retail Mutual Fund business includes various distribution channels, Advice (Financial Planning, Investment Advice and Private Wealth Management) and self-directed. Here are some of the key differences between Institutional investors and Retail Investors. Please keep in mind that I’m speaking in general terms and that individual Institutional clients and Retail clients may have different views/focus.

Primary focus

Retail Investors

One of the biggest problems Retail clients have is their propensity to chase yield. They look for the hottest mutual fund, ETF, stock or crypto-currency. They hear from friends and family about how much they made from Bitcoin or on a Marijuana stock. They also hear about how much these securities have gone up in the media. By the time they get into these securities most of gains have already occurred. This process appears to regularly repeat itself, think, Bitcoin or any other bubbles. By the time mass retail clients enter, the bubble is about to burst.

Institutional Money

In my experience, Institutional clients are also interested in yield but their primary concern is risk management. Don’t get me wrong, yield/returns are a close second. Most institutional clients have an investment committee or an individual whose job it is to work with the Asset Manager to outline needs (when and how much liabilities due) and risk tolerance.

As mentioned, institutional clients primary concern is risk management. They know if the fund is drastically trailing the benchmark, it will require much higher returns in subsequent years. They mitigate these risks by reviewing the Asset Managers risk management methodologies and investment plan.

Risk Management

Retail Investor

Most retail clients don’t have a risk management process in place. They don’t know what type of risks could affect their asset and, in most cases, they don’t bother to learn.

Institutional Money

In the Institutional world, the vetting process of an Asset Manager (end to end sales cycle) on average can take 1 to 2 years. Starting with multiple RFIs (request for information) and/or RFPs (request for proposal). Then multiple meetings with various teams (Portfolio Management (PM) team, Credit Research, Credit Risk, Operational Risk, Trading Team, Technology Risk etc.).

The Portfolio Management Team

The meeting with the PM team initially consists of a review of the investment process (eg investment thesis, expected returns and risks).

Types of risk for the PM

Company /Individual security risk – Individual security risk is when a large portion of a fund is invested in an individual security. This works well when the security is performing well but can pose a significant risk. The stock market is littered with companies that performed well for many years but suddenly turned (eg Nortel, GE).

Sector risk – sector risk is purchasing too many securities from the same or related industry. In Canada, the big five banks have performed relatively well (except for the last year or so). If all or most of your assets are in the banks a downturn in that industry can drastically impact your portfolio.

Currency risk – A good PM is always looking for good companies to invest in. There are many good companies or opportunities outside of North America (Nestle, Royal Dutch Shell). When PMs purchase securities in other countries and the fund is denominated in Canadian or US dollars there’s a currency difference. I’ve seen gains wiped away because the currency moved against them. To mitigate this risk PMs can implement a currency hedge. Of course, this hedging comes at a cost which impacts returns.

Investment Plan

Depending on the institutional client’s risk profile there are various measures that the Asset Manager can utilize to help reduce the volatility of the fund. Here are but a few.

Asset Allocation – Increasing the fixed income (investment grade) component and reducing the equity ratio of a portfolio will help reduce overall volatility.

Low Volatility (LV) Investing – Traditional asset pricing theory states that an asset’s expected return is directly proportional to its beta or systematic risk. In other words, higher risk securities should be rewarded with higher returns. But this is not the case, there have been numerous studies proving low-volatility or low-risk investing outperform the broader market The Low-Volatility Effect.

Protective Puts – A put option provides a buyer of the put to sell their security at a set price for a specific period of time. For this security there is a cost, this cost is called the premium. Some Asset Managers will buy puts or implement option spreads to protect their portfolio.

Dividend Investing – Investing in high-quality dividend stocks with a history of growing dividend and strong free cash flow. Here some findings from an article I found on The Motley Fool and a chart from that shows how the dividend aristocrats performed against the S&P 500. The results show that the dividend aristocrats soundly beat the S&P 500 over the 25 year period.

Individual investors can mitigate the majority of these risk by diversifying their portfolio and implementing similar tactics.  Diversification can be achieved by holding a mix of individual securities or by purchasing several low-cost index ETFs/mutual funds will do the trick.


Retail Investor

Everyone who is familiar with personal finance or investing knows that you should take a longer view of your investments. Unfortunately, most retail customers don’t take this position or more accurately they allow emotions to impact their decision. They are often chasing the hottest trends like marijuana stocks (Is The End Near For Pot Stocks?), Bitcoin or the hottest mutual funds/ETFs (best performing). Usually, this happens after that asset class or security have already made significant increases. If there’s a pullback they sell that security because they are afraid to lose more money. Essentially, they are buying high and selling low.

Institutional Money
Institutional money, on the other hand, has a much longer view. Institutional money consists of government and company pension plans, university endowments and ultra high net worth. The investment committee’s mandate is to ensure money will be available when it is required.  They know that the market moves in cycles and will give the Asset Manager time to work the investment plan.

Final Thoughts

Most retail investors make the fatal mistakes of chasing yield, not properly managing risk and not taking a long-term view on investments. As a result, the average investor earns well below-average returns. Research from Dalbar Inc indicates that the average equity fund investor earned a market return of only 5.19% while the S&P 500 returned 9.85% per year (for the 20 years ending 12/31/2015). That’s a 4.66% difference over that 20-year period.

$100,000 invested over that 20 years at 5.19% (excluding taxes) would result in a current value of approximately $275,000. Not bad returns. That same 100K at 9.85% over the same period would yield over $654,000. That’s $379,000 more if the average investor didn’t make those mistakes.

By being aware of these fatal mistakes and instituting a strong disciplined investment plan, average investors could significantly improve their results.

Are you aware of these common fatal mistakes and are you taking measures to reduce these risks?

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