The difference between retail and institutional investors

130/30 24 Jan 2008

They sure aren’t a silver bullet, but short-selling and using a bit of leverage is a proven way to give a manager more latitude to express her investment opinions.  So it’s always interesting when the concept of 1X0/X0 is summarily dismissed because it’s “unproven” – like some screwy new market, or a derivative that most mortals can’t understand.  The bottom line is that if investors in active funds believe in their managers’ ability to produce alpha – and supposedly they do or they wouldn’t invest with them – then why not give them more latitude (especially when that latitude has a hard cap)?

This article at Kiplinger.com is the latest to poke holes in 130/30 for the wrong reasons.  The magazine that bills itself as “Timely, Trusted Personal Finance Advice…” dispenses some remarkable simplistic advice about 130/30 mutual funds.  It starts like this:

“The mutual fund industry loves to adapt the hard-to-explain strategies of Wall Street for funds aimed at you and me. But sometimes these concepts can be so challenging that the real question is whether the funds are worth the hype. In most cases, probably not.”

You can guess how the piece goes on.  But it’s how the story ends that says a lot about the kind of “trusted personal finance advice” being provided to people like you and me:

“So ignore the hype and wait until there are results…before jumping in.  As [mutual fund] analyst Jeff Tjornehoj stresses, ‘Don’t buy a fund just because it sounds interesting.'”

In other words, disregard the investment strategy, the manager’s “edge”, and other forward-looking factors and instead chase the funds with the best return last year.

Let’s check out what the research says about this approach.  This study, for example, concludes that returns “severely fall off” three years after a mutual fund receives a “5-Star” rating.  And this one concludes:

“Investors in both actively managed funds and index funds exhibit poor investment timing. We demonstrate that our empirical results are consistent with investor return-chasing behavior.”

In fact, research shows that there is very little correlation between a manager’s performance last year and his performance this year.  If there were, then the world’s assets would slosh toward last year’s winners in such volumes they would be immediately swamped.

To be sure, institutional investors also want to see a track record of success before they invest in a particular manager.  But a new strategy (such as the relatively straightforward 130/30 strategy) is judged on its own economic merit, not a particular manager’s ability to prove that merit.  As a result, institutional investors spend about 1% of their time looking at the past and 99% of their time trying to get a feel for the future.  This cultural difference is likely why institutions, not individual investors, have blazed the 130/30 trail.  And it is likely also why mutual fund investors tend to perform even worse than the very mutual funds in which they invest.

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2 Comments

  1. Bill aka NO DooDahs!
    January 24, 2008 at 8:56 pm

    http://www.cxoadvisory.com/blog/external/blog1-24-08/

    “In summary, presumably sophisticated hedge fund investors as a group chase past returns and fail to time their investments successfully.”

    So, are the majority (dollar-weighted) of hedge fund investors “retail” or “institutional?” Just curious.


  2. Alpha Male
    January 24, 2008 at 9:49 pm

    Very fair point, Bill. Hedge fund investors (many of them institutional) sure aren’t immune to return chasing. But based on my experience selling hedge funds to institutions, I’d say it’s a subconscious bias, not am explicit strategy (as we often see with mutual funds). Institutions will often take a year to make a decision and will stick with you for many more than that even if performance is poor. Still, I suppose whether the bias is subconscious or explicit doesn’t really make a difference at the end of the day. There are no points for good intentions. So thanks for keeping us honest.


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