2 posts tagged “funds”
The reason for some institution's refusal to sell their positions that have appreciated dramatically (and that are most vulnerable to decline) can be deeper than the impression desired by publishing the positions. Management's compensation is usually a set percentage of the market value of the assets managed. If a profitable position is sold, the gain may be subject to taxation and paid out to clientele as a capital gains distribution. This effectively reduces the amount of money being managed and the associated fees.
The problems associated with selling positions that have profited most can be particularly acute in small mutual growth funds that have followed the practice of "taking losses and letting profits ride" for an extended period. The result is that their portfolio consists of only a few issues. By having locked themselves into holding a few profitable stocks, the fund's value becomes a function of the value of the rigid holdings and has nothing to do with the overall ability of management.
Keep in mind that money managers are human beings with basic needs such as food and shelter, which require employment. Also recognize that, especially in the larger institutions, clientele are not aware of the identity of the individual analyst making the investment decisions. This anonymity is often strictly enforced and a prerequisite for employment.
In this environment, the individual analyst (whether a genius or an idiot) is under pressure to conform to the crowd. To be too good or too bad relative to one's peers involves risks of criticism or resentment with the associated occupational hazards. This effect is obvious to anyone familiar with the financial media. When an analyst (usually independent) becomes popular because of accurate forecasting and then stumbles, the mistake (even though the overall return over time has been far superior) is pounced on. On the other hand, a spokesperson for a large institutional analytical service that has consistently been wrong, but that is one of the crowd, attracts media attention when making forecasts without criticism of past mistakes.
Understanding the structural aspects of institutional investing practices and employment pressures, you would logically conclude that the average institution would underperform the market, with the underperformance magnified by the fees involved. Yup.
External
Aside from the difficulties associated with internal structure and characteristics, institutions have the added problem of dealing with their clientele. Discretionary clientele who do not properly understand the stock market, although they have entrusted their investment decisions to someone else, often have a tendency to self-destruct. This is particularly evident in mutual funds, whose investors are continually adding or withdrawing (redemptions) money. People tend to add money when the market is highand the mood optimistic. Redemptions tend to dominate when the marketis low and the mood pessimistic.
The institutions are forced to invest the money—that is what they arebeing paid to do. Therefore, with more money coming in when the market is high, the institutions so affected are forced to buy at relatively high levels. Conversely, when redemptions dominate and the market is low, the institutions are forced to sell at depressed prices to fulfill the investor'sdemand for cash.
From the professional standpoint, the process is marvelous. We knowwe have buyers at high prices and sellers at low prices because of the demands of discretionary clientele creating a supply/demand imbalance. When they are doing their forced buying, it creates underlying buying demand and we can raise our prices. When they are forced to sell, we know there is "overhanging supply," and we can lower our purchase prices.
This buy-high/sell-low behavior (required to fulfill clientele's wishes) is not limited to mutual funds. It can affect any funds that can redeem or add capital according to their client's emotions: bank trust departments, pension funds, and the like. An important exception is closed-end mutual funds where the capital base is fixed and the investor must buy/sell shares in the open market rather than affecting the funds' specific holdings.
The market is a business. The purpose of the business is to acquire the monies of others through the process of buying low and selling high. Because of the anonymous nature of trading structure, it is very difficultto specifically identify the individual to whom you are selling or from whom you are buying. Consequently, physical coercion to create losingbehavior among fellow market participants cannot be applied. People do not enter the market to lose. However, they must be placed in a situation in which they will willingly part with their money. The only way to elicit losing behavior is psychological pressure. The most effective tool for applying the pressure is a change in market price. Faced with "paper" losses, those vulnerable to the emotion associated with "apparent" losses will capitulate, accepting the loss in the form of cash to relieve thepsychological strain.
The discretionary manager is subjected to the same emotional pressuresas all other market participants. It is not uncommon for discretionary managers to buckle under the pressure and sell low in direct conflict with historical or statistical precedent to alleviate pressures both self- and clientele-imposed. Conversely, when prices are too high, the emotionallure of greed can stimulate buying when prices are most vulnerable to severe decline. Those who conduct themselves professionally are acutelyaware of the psychological effects of price on institutional managers and take advantage. Such advantage is possible only by strict adherence to a methodology that prevents being lured into the irrational (emotional) behavior of the crowd. This is easily accomplished by having predetermined buy/sell points dependent upon market condition, not price in itself.
The forced behavior of institutions provides one of the most important profit centers for the true professional.
This group consists of pension funds, mutual funds, mutual insurance companies, bank trust departments, brokerage firms that accept discretionary accounts, and any other entity that invests monies on behalf of those who have entrusted their funds. The institution may use pooled monies (mixing together the monies of many different individuals) or invest for others on an individual basis.
There is a significant difference between institutional money management and most other professions. Doctors can (sometimes) bury mistakes. Attorneys can befuddle their clients about why their case was lost. Administrators can attribute mistakes to staff. Politicians can cast blame on predecessors. But institutional money managers have nowhere to hide: Either they have made money or they have not.
To check institutional results, all you need to do is see how the money under management performed relative to some predetermined standard, the most popular standard being major market averages. Many investors might be surprised that most institutions are unable to outperform the market and/or profit consistently.
This is not to imply that institutional managers are ignorant, for many of them are quite competent. The difficulties, even for the most astute manager, can be inherent in the structure of the institutions themselvesand the market.
The primary advantage of institutions is their financial power. Because of the large amounts of money at their disposal, their investment actionscan significantly affect the supply/demand balance and consequently price changes.
The Problems of Institutional Investing
This financial power can also function as a disadvantage because of a lack of maneuverability and liquidity. Dealing with large dollar volumes, institutions often find themselves with very large stock positions. When the time comes to sell, there might not be enough buyers to purchase the large amount of stock unless the price is lowered significantly. In such instances, institutions can be forced to accept lower prices when they sell. Conversely, when they buy, they can be forced to pay higher prices because of the large amounts of stock involved. Of all investor groups, institutions are the mostpredictable, and as such they are frequently preyed upon by true professionals.
In isolating the institutional characteristics that afford profit opportunity, it is possible to categorize institutions as to type (pension funds, mutual funds, etc.), ethical standards (high, low, none), investment strategies (fundamental, technical, etc.), method of funding (constant or variable), and taxation (immediate or deferred).
The institutional manager is, by definition, in the business of investing the monies of others and consequently is influenced by both the attitudes and actions of clientele. The source of the capital can have a significant influence on performance. The greater the stability of the funds that are being added/withdrawn, the easier the task of management.
