A good friend asked me if individual investors can compete fairly with institutions and hedge funds. It is an important question and perhaps not discussed frequently enough.
I would argue strongly that the answer is yes, but only if your time frame is medium to long-term. How can I hold this level of confidence when institutions appear to hold the aces? After all, they are far better capitalized and have access to instant information.
Individual investors can feel that they are getting the short end of the stick. Forty years ago they dominated the equity markets. Over the decades there has been a complete role reversal. In today's choppy and somewhat directionless equity markets, one can feel like a rag doll being tossed between high-frequency traders.
Where the individual investor can come up short
Real-Time Information. We are the last to receive breaking news. Instantaneous data feeds the institutional machine. Individuals are not going to get the real-time level of detail on disappointing earnings or a management shuffle. Leave active trading to the pros. You have no edge.
Fund Flows. If you lengthen your investment time frame, institutional short-term trading that gyrates the equity markets is just noise. Stock valuations might be affected for the day or perhaps a week and then normalized valuations come back into play. Stay out of their way and simply lengthen your time frame.
Specialized Access. Institutions do have an edge on investment research and introductions to management. I question if this additional level of due diligence adds to investment success. Based on history, active institutional managers underperform their respective benchmarks up to 70% of the time. Perhaps corporations tell institutional investors what they want to hear. Institutional grade research, may leave them feeling better informed, but is this additional information reflected in outperformance?
Transaction Costs. Trading costs have historically been a meaningful drag on performance, giving institutions an edge on fees, but times have changed. If your security hold period is medium-term, transaction fees are minimal.
Access. Institutions have better access to deal flow or specialized opportunities. This institutional advantage can be meaningful with attractive private debt / private equity pricing.
Large Investors Only. Institutions have access to otherwise closed strategies. Some of the best hedge fund managers have very high minimums or are accessible by invitation only.
Long Time Frame. There is considerable value in being able to make multi-generational investments in sectors such as infrastructure. Institutions can consider very long-term investments beyond many individuals' time frame.
How can the Individual Investor compete?
No Investment Committee. The individual investor has no one to answer to or second guess investment decisions. This is a big advantage. Imagine an investment committee constantly pushing you to beat your benchmark. A professional investment manager's one to three-year performance numbers better be upper quartile or their mandate might be at risk. Pressured decisions are not usually the desired course of action.
You, as an individual investor can act in your own best interests. No committee looking over your shoulder allows for a personalized strategy; from asset allocation, to risk parameters, time frame, active versus passive and targeted return.
Liquidity. With institutional pools of capital often in the billions of dollars, a lack of liquidity can restrict their opportunity set. As an individual, with a medium-term time frame, liquidity should not be an issue. Mid-cap to small-cap equities may not trade in sufficient volume to allow institutional participation, allowing individual investors to dominate in this segment of the equity markets.
Cash Flows. The individual investor controls their own cash flows. One is not affected by the needs of others. Institutional money managers may have to hold cash reserves or sell securities to fund redemptions. This forced selling can be pronounced at market bottoms, just when one would be more inclined to buy.
(source; Mortonir.com)
Technology has allowed investors to compete on a reasonably level playing field. I would argue that what holds back individual investment performance is not the competition, but their own actions. Purchasing the latest hot sector, failure to diversify, and pure speculation are a few of the investment traps.
A well-thought-out investment plan, rigorously adhered to will compete very evenly with the institutional investor.
regards, Tim
Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your professional advisor for investment advice.
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