2 posts tagged “mutual”
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.
The stability factor can be clearly demonstrated in open-end mutual funds where the investors can add money (that is, buy mutual fund shares) or withdraw money (through mutual fund redemptions) at any time. Mutual fund sales are highest during periods of euphoria when the public's greed has been stimulated after seeing stock prices advance significantly. The fund manager is forced to invest the monies coming in because that is what those investing expect. In effect, the manager is being forced by the institution's structure to buy at high prices. When prices falter and the investors become fearful and/or disgusted, they want to redeem. To meet the investor's demand for cash, the institutional manager is forced to liquidate stock positions at low prices. In effect, through no fault of personal investment ability, the manager so placed is forced to buy high and sell low—the precise formula for disappointment. Even without net redemptions, this basic problem is further compounded by the fact that there is more money to be invested when stocks are overpriced than when stocks are underpriced.
The Sheep Syndrome
Irrespective of the stability aspect, almost all institutional managers are under pressure to achieve acceptable relative performance. That is, the manager does not want to look bad when compared to other managers. This results in what we term the "sheep syndrome," which is the predictable herdlike behavior of the majority of managers who make identical judgments as to their movement into, out of, and within the market. As with their animal counterparts, those who stray or straggle behind are easy targets for the crafty predator. And the herd itself, relatively defenseless because of predictability, has no great strength in numbers when attacked.
To understand this phenomenon, try to empathize with the institutional manager. He or she has certain goals and needs, among which survival through job preservation is of prime consideration. Most portfolio managers, although tending to exhibit little individuality, believe themselves to be in a very competitive environment and are keenly aware if they are over- or underperforming their peers. As long as everyone is doing about the same thing, the status quo is maintained and all proceeds relatively smoothly. The manager who does not stay with the crowd is easily singled out and comes under the scrutiny of others. The manager who demonstrates exceptionally profitable performance has effectively shown up the others and, as a result, may be resented rather than applauded. A manager who underperforms only draws attention as being inferior to the crowd.
In the market, it is mathematically impossible to be correct all the time. Therefore, when a maverick manager (even though consistently doing better than others over time) does make a mistake, it attracts inordinate attention. The result can be analogous to a baboon like cuffing when one of the adolescents gets out of line. In a more civil context, it is peer pressure. This pressure can intimidate a manager into thinking that the investing public is focusing attention on the error and into magnifying the imagined detrimental effects to his or her image.
This real and/or supposed pressure can make even the most original manager fall into line with the others. In other words, the manager may be forced into what may be considered a herd of other managers. But not all managers choose the herd because of peer pressure. It is also a convenient place to disguise incompetence or lethargy. Just do what the others do and you will never be singled out as less capable. This also reduces the possibility of being disliked, which enhances the chances of obtaining alternate employment if it should become desired or necessary.
Our observation of the effects of peer pressure among institutional managers is far from theoretical. It is not unusual to see institutional managers have their personal funds managed under strategies far different from those employed by the institution itself.
