The Institutional Performance Derby
The Short-Term Relative Performance Derby
The great majority of institutional investors are plagued with a short-term, relative-performance orientation and lack the long-term perspective that retirement and endowment funds deserve. Myriad rules and restrictions, often self-imposed, also impair the ability of institutional investors to achieve good investment results.
Today institutional investors dominate the financial markets. All investors are affected by what the institutions do, owing to the impact of their enormous financial clout on security prices. Understanding their behavior is helpful in understanding why certain securities are overvalued while others are bargain priced and may enable investors to identify areas of potential opportunity.
If the behavior of institutional investors weren’t so horrifying, it might actually be humorous. Hundreds of billions of other people’s hard-earned dollars are routinely whipped from investment to investment based on little or no in-depth research or analysis. The prevalent mentality is consensus, groupthink. Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance. Indeed, the short-term, relative-performance orientation of many money managers has made “institutional investor” a contradiction in terms.
Institutional investors are presumably motivated both by the ongoing challenge of achieving good investment results and by the personal financial success that accrues to participants in a profitable money management business. Unfortunately for investment clients these objectives frequently are at odds. Most money managers are compensated, not according to the results they achieve, but as a percentage of the total assets under management. The incentive is to expand managed assets in order to generate more fees. Yet while a money management business typically becomes more profitable as assets under management increase, good investment performance becomes increasingly difficult.
The business of money management can be highly lucrative. It requires very little capital investment, while offering high compensation and the rapid development of what is effectively an annuity. Once an investment management business becomes highly profitable, it is likely to remain that way so long as clients do not depart in large numbers.
As a result, the pressure to retain clients exerts a stifling influence on institutional investors. Since clients frequently replace the worst-performing managers, most managers try to avoid standing apart from the crowd. Those with only average results are considerably less likely to lose accounts than are the worst performers. The result is that most money managers consider mediocre performance acceptable. Although unconventional decisions that prove successful could generate superior investment performance and result in client additions, the risk of mistakes, which would diminish performance and possibly lead to client departures, is usually considered too high.
Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative-performance derby. Numerous managers are provided daily comparisons of their results with those of managers at other firms. Frequent comparative ranking can only reinforce a short-term investment perspective. It is understandably difficult to maintain a long-term view when, faced with the penalties for poor short-term performance, the long-term view may well be from the unemployment line.
What is a relative-performance orientation? Relative performance involves measuring investment results, not against an absolute standard, but against broad stock market indices, such as the Dow Jones Industrial Average or Standard & Poor’s 500 Index, or against other investors’ results. Most institutional investors measure their success or failure in terms of relative performance. Money managers motivated to outperform an index or a peer group of mangers may lose sight of whether their investments are attractive or even sensible in an absolute sense.
Instead of basing investment decisions on independent and objective analysis, relative-performance-oriented investors really act as speculators. Rather than making sensible judgments about the attractiveness of specific stocks and bonds, they try to guess what others are going to do and then do it first. The problem is that even as one manager is attempting to guess what others may do, others are doing the same thing. The task becomes increasingly intricate: guess what the other guessers may guess. And so on.
There are no winners in the short-term, relative-performance derby. Attempting to outperform the market in the short run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. The effort only distracts a money manager from finding and acting on sound long-term opportunities as he or she channels resources into what is essentially an unwinnable game. As a result, the clients experience mediocre performance. The overall economy is also deprived, as funds are allocated to short-term trading rather than to long-term investments. Only brokers benefit from the high level of activity.
Other People’s Money vs. Your Own
You probably would not choose to dine at a restaurant whose chef always ate elsewhere. You should be no more satisfied with a money manager who does not eat his or her own cooking. Economist Paul Rosenstein-Rodan has pointed to the “tremble factor” in understanding human motivation. “In the building practices of ancient Rome, when scaffolding was removed from a completed Roman arch, the Roman engineer stood beneath. If the arch came crashing down, he was the first to know. Thus his concern for the quality of the arch was intensely personal, and it is not surprising that so many Roman arches have survived.”
Why should investing be any different? Money managers who invested their own assets in parallel with clients would quickly abandon their relative-performance orientation. Intellectual honesty would be restored to the institutional investment process as the focus of professional investors would shift from trying to outguess others to maximizing returns under reasonable risk constraints. If more institutional investors strove to achieve good absolute rather than relative returns, the stock market would be less prone to overvaluation and market fads would less likely be carried to excess. Investments would only be made when they presented a compelling opportunity and not simply to keep up with the herd. Impediments to Good Institutional Investment Performance
One major obstacle to good institutional investment performance is a shortage of time. There is more information available about securities, as well as corporate and macroeconomic developments, than anyone could reasonably digest. Just sifting through the accumulating piles of annual reports, Wall Street research, and financial periodicals could consume all of one’s time every day. Thinking about and digesting all this material of course, would take considerably longer.
An investor’s time is required both to monitor current holdings and to investigate potential new investments. Since most money managers are always looking for additional assets to manage, however, they spend considerable time meeting with prospective clients in addition to hand-holding current clientele. No single meeting places an intolerable burden on a money manager’s time; cumulatively, however, the hours diverted to marketing can take a toll on investment results.
Another difficulty plaguing institutional investors is a bureaucratic decision-making process. While managing money successfully is not easy for anyone, many institutional investors compound that difficulty with a tendency toward conformity, inertia, and excessive diversification that results from group decision making.
Any institutional investor with an innovative or contrarian investment idea goes out on a limb. He or she assumes a personal risk within the firm, which compounds the investment risk. The cost of being wrong goes beyond the financial loss to include the adverse marketing implications as well as the personal career considerations. This helps explain why institutional investors rarely make unconventional investments. It also shows why they tend to hold onto fully priced or overpriced investments, unwilling to recommend sale unless a consensus for selling has already emerged. The multidimensional risk from holding too long is usually less than the risk in selling too soon.
Selling is difficult for money managers for two additional reasons. First, many investments are illiquid, and disposing of institutional-sized positions depends on more than simply the desire to do so. Second, selling creates additional work as sale proceeds must be reinvested in a subsequent purchase. Retaining current holdings is much easier. With so many demands on their time, money managers have little incentive to create additional work for themselves.
Many large institutional investors separate analytical responsibilities from portfolio-management duties, with the portfolio managers senior to the analysts. The portfolio managers usually function on a top-down basis, integrating broad-scale market views with the analysts’ recommendations to make particular investment decisions. This approach is conducive to mistakes since the people making the decisions have not personally analyzed the securities they are buying and selling. Moreover, the analysts who do have direct knowledge of the underlying companies may be swayed in their recommendations by any apparent top-down bias manifested by the portfolio managers.
There is one other impediment to good institutional investment performance: institutional portfolio managers are human beings. In addition to the influences of the investment business, money managers, despite being professionals, frequently fall victim to the same forces that operate on individual investors: the greedy search for quick and easy profits, the comfort of consensus, the fear of falling prices, and all the others. The twin burdens of institutional baggage and human emotion can be difficult to overcome.
Implications of Portfolio Size
Institutional investors are caught in a vicious circle. The more money they manage, the more they earn. However, there are diseconomies of scale in the returns earned on increasingly large sums of money under management; that is, the return per dollar invested declines as total assets increase. The principal reason is that good investment ideas are in short supply.
Most of the major money management firms consider only large-capitalization securities for investment. These institutions cannot justify analyzing small and medium-sized companies in which only modest amounts could ever be invested.
To illustrate this point, consider a manager at a very large institution who oversees a $1 billion portfolio. To achieve reasonable but not excessive diversification, the manager may have a policy of investing $50 million in each of twenty different stocks. To avoid owning illiquid positions, investments might be limited to no more than 5% of the outstanding shares of any one company. In combination these rules imply owning shares of companies with a minimum market capitalization of $1 billion each. Unfortunately for the clients of large money managers, thousands of companies are automatically excluded from investment consideration regardless of individual merit.
Remain Fully Invested at All Times
The flexibility of institutional investors is frequently limited by a self-imposed requirement to be fully invested at all times. Many institutions interpret their task as stock picking, not market timing; they believe that their clients have made the market-timing decision and pay them to fully invest all funds under their management.
Remaining fully invested at all times certainly simplifies the investment task. The investor simply chooses the best available investments. Relative attractiveness becomes the only investment yardstick; no absolute standard is to be met. Unfortunately the important criterion of investment merit is obscured or lost when substandard investments are acquired solely to remain fully invested. Such investments will at best generate mediocre returns; at worst they entail both a high opportunity cost—foregoing the next good opportunity to invest—and the risk of appreciable loss.
Remaining fully invested at all times is consistent with a relative-performance orientation. If one’s goal is to beat the market (particularly on a short-term basis) without falling significantly behind, it makes sense to remain 100% invested. Funds that would otherwise be idle must be invested in the market in order not to underperform the market.
Absolute-performance-oriented investors, by contrast, will buy only when investments meet absolute standards of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, preferring to remain less than fully invested when both conditions are not met. In investing, there are times when the best thing to do is nothing at all. Yet institutional money managers are unlikely to adopt this alternative unless most of their competitors are similarly inclined.
The Abandonment of Fundamental Investment Analysis by Institutional Investors
Over the past several decades there has been an enormous increase in the amount of money managed by people who knowingly ignore the underlying fundamentals of the investments owned. Academic notions, such as the efficient-market hypothesis and capital-asset-pricing model, support these strategies. Indexing is the primary investment outlet for investors who believe in these ideas. Practices such as tactical asset allocation, portfolio insurance, and program trading share to a greater or lesser extent the same disregard for investing based on company-by-company fundamentals.
Investors must try to understand the institutional investment mentality for two reasons. First, institutions dominate financial-market trading; investors who are ignorant of institutional behavior are likely to be periodically trampled. Second, ample investment opportunities may exist in the securities that are excluded from consideration by most institutional investors. Picking through the crumbs left by the investment elephants can be rewarding.
Investing without understanding the behavior of institutional investors is like driving in a foreign land without a map. You may eventually get where you are going, but the trip will certainly take longer, and you risk getting lost along the way.