How Could Individual Investors Outperform Institutional Investors?Download this article in PDF
Portfolio management is the art and science of making decisions about mixing investment with policy, matching investments to objectives. Within Crèdit Andorrà, the Advisory team is dedicated to portfolio construction and to guiding clients on capital markets.
There are two categories of investors in the financial markets: individual investors and institutional investors. The term institutional investors refers to just what the name implies: large institutions, such as banks, insurance companies, pension funds, and mutual funds.
Institutional investors outperform individual investors
Institutional clients usually use a benchmark to manage their portfolios, meaning that they have to follow defined rules of asset allocation that they cannot derive too much from. Those rules are hard constraints, with a defined level of active exposure (also called tracking error) that they can implement. Those hard constraints oblige them to own assets on which they have negative views, which is highly inefficient. More constraints are usually bad for portfolio management if you are talented, as you cannot completely implement your views on capital markets. As most of the portfolios from individual investors are not benchmarked, their portfolios’ returns should on average outperform the ones from institutional clients. However, we are seeing the opposite as institutional clients outperform individual clients by 1% per year on average. We explore the reasons behind this phenomena and what could be done to reduce this performance gap.
Outperformance is less due to skills differential
One could think that this outperformance mostly comes from skills. Institutional money, which is also called “smart money”, is managed by professionals that not only have a lot of experience in managing money but also dedicate 100% of their time to this activity. On the other hand, individuals usually manage their portfolio when they have the time, mostly during weekends or at night, and they do not always have the technical background to do so.
However, most of the outperformance is not due to the difference in skills, but to basic mistakes coming from individual investors that could be easily corrected.
Thanks to investment behavioural mistakes
For instance, we see patterns of investor behaviour biases that have a negative impact on portfolio returns. Most clients have a home bias, which is the natural tendency for investors to invest in large amounts in domestic markets because they are familiar with them. This results in an unnecessary concentration in assets and less portfolio diversification. In addition, many Latin clients look for assets that provide yields, as they perceive them as being less risky. This is not true, as the demand for this type of assets is high and, therefore, they end up being expensive from a valuation point of view. Finally, individuals have a bias towards loss aversion. Loss aversion refers to people’s tendency to strongly prefer avoiding losses rather than acquiring gains. As a result, investors keep assets in their portfolio with large losses for years even though those assets have very little probability of recovery.
We believe that individual investors could reduce the performance gap with institutional investors by simply focusing on three aspects of portfolio management:
#1 Focus on diversification by holding alternative assets
Everybody knows that diversification is key in portfolio management. But the reality is that few portfolios are well diversified within private banks. Many Latin American clients’ portfolios are only invested in US stocks and emerging market bonds, which is a strategy that has worked very well over the last 3 years. There are benefits to being exposed to direct names to reduce the cost of management fees; however, it is also primordial to use funds to benefit from diversification. Indeed, it is wiser to use funds in the following asset classes: high yield bonds, preferred shares, catastrophic bonds, small caps Equity, and emerging markets equities.
We believe that most portfolios should have an exposure to the alternative assets class. We define alternative assets as those assets that have a low correlation with equity and fixed income.
Those are strategies such as long/short equity, CTAs, Global Macro, Merger Arbitrage, Real Estate and Private Equity, for instance. Adding alternative assets allows portfolios to be more robust during phases of market correction; in other terms, they reduce downside risks.
#2 Focus on the right asset allocation instead of on picking securities
The second advice is to stop spending too much time on picking the right securities. What is important is asset allocation, where most of the portfolio performance will come from. A top down approach should be implemented to determine the right exposure to equity vs. fixed income, at the region level and sector level.
Indeed, what is important is not if you own Facebook instead of Google, but your exposure to technology vs. energy, as technology has been the best performing sector in the US this year and energy the worse one. Stocks within the same sector tend to be highly correlated in average.
A common mistake for individual investors is to do the opposite. They focus on trade ideas applying a bottom-up approach without taking the interconnection amongst all those ideas.
Worse, they usually cumulate all the trading ideas without having specific target returns and stop losses. If the ideas do well, they will sell it -most of the time too early. And if the ideas do not work, they will keep it until they recover their losses. This is a bad idea, as returns are auto correlated (following a negative return, an asset has a higher probability to go down than to go up).
#3 – Do not overreact by taking more risks than you can afford
Following a market correction, some individual investors start to feel nervous and prefer to sell their positions, basically selling at the worse time. This happens because they took more risks than they could afford.
The most important question investors should be able to answer is how much they can lose before they start selling their positions, basically knowing their capacity to lose investments. Once you know that the most you can lose is a 20% for instance, you can manage your risk exposure accordingly.
To manage your risk, you need to rebalance you portfolio on a regular basis. As equity usually tends to outperform fixed income, its weight in the portfolio increases over time. Rebalancing allows a reset of the portfolio to the initial portfolio weight.
We saw that institutional money tends to be benchmarked, which adds constraints for portfolio management. Individuals, on the other hand, do not have all those constraints. By focusing on diversification, asset allocation, and risk tolerance, they can generate alpha and manage risks efficiently in the long term.
Stephane Prigent, CFA, Managing Partner Katch Investment Group
September 10th 2017