How could individual investors outperform institutional investors?

Investment portfolio management is the art and science of making decisions by mixing investment and policy, linking investments to objectives. At Credit Andorra, the advisory group is dedicated to structuring investment portfolios and guiding clients through the exciting world of the capital market.

There are two categories of investors in the financial markets: individual investors and institutional investors. The term institutional investor is as the name suggests: 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, which means that they must follow defined asset allocation rules that do not allow them to deviate much from that reference. Those rules are strong constraints, with a defined level of asset exposure (also called tracking error) that they can implement. Some of these strong restrictions, force them to acquire assets where they can have a negative perspective, which is extremely inefficient. Such restrictions are usually bad for portfolio management, because if there is talent or expertise in asset management, it is not possible to fully implement the perspectives they have of the capital market. On the other hand, most individual investors’ portfolios do not have a benchmark, so portfolio returns should, on average, exceed those of institutional investors. However, we are seeing the opposite, institutional investors on average outperform individual investors by 1% per year.

We explore the reasons behind this phenomenon and what could be done to reduce this performance gap.

The skill gap is not the main reason for the higher return

One might think that the greatest performance comes mainly from skills. Institutional money that is also called “smart money” is managed by professionals who not only have a lot of experience in asset management, but are also dedicated 100% of their time to this activity. On the other hand, individual investors usually manage their portfolio when they have time, mainly during the weekend or in the evenings, and do not always have the technical knowledge to do so.

However, the performance gap is not due to the difference in skills, but to basic mistakes that come from individual investors that can be easily corrected.

Investment behavior errors in investors

For example, some patterns can be detected that bias investor behavior and negatively impact portfolio returns. Most clients have a “home bias”, which is a natural tendency of the investor to invest high amounts in local markets since they are familiar to them. This results in unnecessary asset concentration and less diversification of the portfolio.  In the case of Latin American investors, they also tend to look for assets that provide dividends as they are perceived to be less risky. This is not true; as demand for this type of asset is high, this type of asset ends up being expensive (from a valuation point of view). Finally the individual investor is adverse to lose. Risk aversion refers to the tendency of people to strongly prefer to avoid losses than to acquire profits. As a result, the investor keeps assets in his portfolio with large losses for years even though the assets are less likely to recover.

We believe that individual investors can reduce the performance gap with institutional investors simply by focusing on three aspects of portfolio management:

#1 Focus on diversification through alternative investments

Everyone knows that diversification is the key to portfolio management. But the reality is that few portfolios are well diversified within private banks. Many Latin American client portfolios are only invested in U.S. stocks and emerging market bonds, which is a strategy that has worked very well over the past three years. There are benefits to having direct exposure to specific assets to reduce the cost of management fees, however, it is also paramount to use funds to benefit from diversification. In fact, it is wiser to use funds in the following asset classes: high-yield bonds, preferred stocks, catastrophe bonds, small-cap stocks and emerging market stocks.

Most portfolios should have an exposure to alternative assets. Assets that have a low correlation with stocks and bonds are defined as alternatives. Those are strategies like: long / short equity, CTAs, Global Macro, Merger Arbitrage, real estate and private equity. Adding alternative assets allows the portfolio to be more robust during the correction phases in the market. In other words, it reduces the downside risk.

#2 Concentrate on proper asset allocation rather than asset selection.

The second tip is to stop spending too much time on the proper selection of assets, what is important is the asset allocation where most of the portfolio performance will come from. A top down approach should be implemented to determine the correct exposure to equities against fixed income, at the regional and sector level.

In fact, what is important is not whether you invest in Facebook rather than Google, but your exposure to technology versus energy, as technology has been the best performing sector in the US this year and energy the worst. Stocks within the same sector tend to be highly correlated on average.

A common mistake made by individual investors is to do the opposite. They focus on buy / sell ideas applying a bottom up approach without taking the interconnection between all those ideas. Even worse, they tend to accumulate all the buy / sell ideas without having specific return targets and loss limits. If the ideas get it right, they will sell, most of the time, too soon. And if the ideas don’t work, they will hold the asset until they recoup their losses. This is a bad idea as returns are “self correlated” (after negative performance, an asset has a greater chance of going down than going up).

#3 Don’t overreact by taking more risks than you can afford

After a market correction, some individual investors start to feel nervous and prefer to sell their positions, basically selling at the worst time. This happens when they took more risks than they could afford.

The most important question an investor should be able to answer is: “How much can I lose before I start selling my positions?” This question allows you to really know your ability to take losses. Once you quantify that the most you’re willing to lose is 20% (for example), you can manage your risk exposure consistently.

To manage your risk, you need to rebalance your portfolio on a regular basis. As equities tend to outperform fixed income, their weight in the portfolio increases over time.

The rebalancing allows the portfolio to be readjusted to the initially proposed weightings.

Conclusion:

Institutional money tends to have a reference or benchmark, which adds restrictions for the management of the investment portfolio. Individuals, on the other hand, don’t have all of those limitations. By focusing on diversification, asset allocation and risk tolerance, they can generate alpha and manage risk efficiently over the long term.

 

Stephan Prigent, CFA
CEO, Katch Investment Group

To learn more, contact us at:
info@kb-familyoffice.com

 

September, 2017

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