4 posts tagged “institutions”

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 predetermi_ned 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.

There are many of the difficulties encountered by institutional management. In this discussion our interest is on identifying pressures that often make discretionary managements conductthemselves in predictable, repetitive patterns. There are two basic source_sof pressure:

• Internal factors, primarily influenced by institutional structure.
• External factors, primarily influenced by the actions of clientele who have placed their funds under discretionary management.

Internal

Institutional management, whether the contributions are voluntary or involuntary, incorporates two basic elements: sales and performance. Of the two, sales is more important because if no reason is given for the contributor to entrust monies, the contributor is not going to do so. And with no money to manage, there is no institution. Elementary.

The primary institutional sales tool is image. Astute, presumably educated, well dressed personnel, plush surroundings, organizational names indicating solidarity, and other superficial characteristics are effectively utilized to project an image. Most investors buy the impression.

The average investor neither wants to take the time nor has the inclination to make objective comparison of the relative performance of the many institutions. Often the institution is chosen without any comparison because of a personal friendship with the institutional manager or salesperson, response to advertising, or media hype. For these poorly informed investors, the greatest influence on their choice of discretionary management is paid advertising, which makes the larger (more heavily advertised) institutions appear preferable. We do not intend here to demean sales. Salesmanship is an integral part of all societies; it is involved in politics and religion, as well as in the overall economy. Our point is to emphasize the sales aspect of institutional structure because it is often overlooked byinvestors, and it forms the basis of some predictable institutional market behavior.

While most investors are not keenly aware of the differences in performance among institutions, most institutional managers definitely are. With their firms having costumed and situated themselves in similar surroundings, the managers must do something more to enhance their sales. The obvious factor to emphasize is performance. However, this creates a dilemma since most institutions fare relatively poorly over time. Irrespective of what the institution has really accomplished for clientele, it isobligated (to assure its existence) to make past performance look as good as possible.

For those institutions that publish their holdings, the easiest way to project the image of superiority is for the holdings to have appreciated dramatically since the time they were purchased. The accomplishment of this task is within the grasp of any attentive third-grade student: sell holdings that are losing and retain those that have appreciated. Then—ah ha—when the institution's holdings are published, it will provide the image that the institution has a fantastic ability to achieve superior results. To add to the image, right before the holdings are to be published, the manager determines which stocks have gone up the most and are receiving the most positive media attention, and then buys some irrespective of the current high price. The end result is a published portfolio that is stuffed with winners and the "hottest" current stocks. The impression is that the institution has both a history of winning and continues to be "on top of the market" by having positions in those stocks currently in vogue.

This process of adjusting portfolio for the sake of appearance—window dressing—is most pronounced when the majority of institutions publish their quarterly portfolios, on or near the last day of March, June, September, and December. As might be expected, the window dressing effect is most dramatic during December when it is combined with selling by the public and others for tax reasons.

The problem with window dressing is, of course, that it not only involves the precise formula for loss (buying high and selling low), but also precludes optimal profit capture by retaining positions that are too high and destined to fall.

To those who conduct themselves professionally, being aware of the influence of window dressing adds to the benefits obtained by normal shifting in relative strength. In effect, window dressing aggravates pricing, making prices too high/low than they would be without the effect. Being aware of the window dressing pressures in combination with normal rotational shifts in relative strength can, in itself, more than double the return available from the market as a whole as measured by the popular averages.

The risks associated with portfolio modification for the sake of appearance are magnified in management techniques stressing "growth" stocks. Retaining a position simply because it has attained an exceptionally large gain could involve the stock's being in the attainment phase of the life cycle concept. In this phase quality stocks are most vulnerable to steep, often sudden price declines.

The primary criterion, be it P/E or price, will not always give a buy/sell indication. In fact, most of the time (and sometimes for very long periods) the primary criterion will not meet the parameters to form the preliminary basis for a change in basic portfolio modeling. The primary criterion (depending on which method—projected earnings, lagging P/Es, or price—is chosen) is by far the most time consuming aspect of our timing technique.

The ancillary criteria are designed to confirm or reject the primary indication. The ancillary criteria (aside from a few rare exceptions) will always be issuing a buy or sell bias. Without an indication from the primary criterion, there is no need to be concerned with the ancillary facets in basic portfolio modeling because there can be no change.

There are twelve ancillary criteria, which might at first seem too burdensome to calculate. However, most (if not all) can be determined by a casual glance at major financial publications (Barron's or The Wall Street Journal). A weekly review of the ancillary criteria can probably be attained within 10 minutes after the sources are identified.

For the ancillary criteria to confirm the primary criterion, a minimum of six ancillary criteria must be in place.

Institutional Cash Reserves

If all markets involve predator/prey relationships, to acquire the cash of others requires that the others actually have cash from which they can be parted. Because of the specific stocks we utilize, as well as the growing dominance of institutions in day-to-day trading patterns, those institutions against whom we compete are important sources of profit.

The term institutional cash reserves refers to the ratio of institutional holding of cash (or cash equivalents) to common stock. The higher the institutional cash reserves, the more money they have available for the purchase of stock. The lower the cash reserves, the lower the institution's ability to buy stock irrespective of sentiment. To emphasize the importance of this institutional cash:noncash ratio, it was all you needed to understand to avoid the crash of 1987. At the time, the institutions were so lured into the stock market and their cash reserves became so depleted, they could not support stock prices. It was an inevitable splat time because of the depletion of possible buying demand.

Institutional cash reserves are tabulated regularly by a variety of surveys that scan mutual funds and/or pensions (Lipper, Herzfeld, a wide variety of brokerage firms, and the like) and the results regularly published in major financial publications.

For our purposes, all we need to know is the change in the cash:noncash ratio relative to where it was four weeks ago (or the next nearest reporting period depending on the source utilized).

BUY: The cash amount has increased. We have isolated potential buying demand that can be lured into the market to push prices higher.

SELL: The cash amount has decreased. The institutions are depleting their buying power, making themselves increasingly weak (perhaps helpless) in providing price support and thereby allowing selling supply to more easily dominate and depress prices.

Public Cash Reserves

Because of the rapid growth of institution's dominating trading activity, it has become popular to dismiss the public as an important market factor. However, as we have discussed in detail in previous chapters, the public is a very important factor, not only because of the predictable behavioral patterns of individuals, but because of the effects these patterns have on the institutions in which the public has entrusted funds.

We monitor this group's cash status by the weekly reporting of the total assets of money market funds. Money market fund assets include monies from groups other than the public, but for our purposes the changes in money market fund assets is all that is necessary for this criterion.

The weekly money market fund asset figures are reported in all major financial publications. Our comparison period is four weeks.

BUY: The amount (gross, no ratio needed) has increased. This isolates potential buyers (buying demand) and the associated potential for higher stock prices.

SELL: The amount has decreased. The amount of potential buying demand is lessening, and selling supply can more easily become dominant to depress stock prices.

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 themselve_sand 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.