Investing is a fascinating place to play. It is one of the few professions where an individual investor, also known as a retail investor, who knows what they are doing, has an advantage over an institutional investor, also referred to as a professional money manager, such that you can outperform these pros in the long term.

It sounds unreal, but let’s delve into the reasons behind this claim:

The Disadvantages of Institutional Investors

Institutional money managers face several limitations that hinder their ability to perform optimally. The main shortcomings are:

A Short-Term Focus

Investment funds typically manage assets on behalf of clients, including pension funds, endowments, and Fund of Funds. These clients often expect regular updates on their investments, sometimes as frequently as quarterly or monthly. Consequently, if a fund manager experiences several months or quarters of poor performance, they will face scrutiny from their clients.

Given that a fund manager’s income is directly tied to the fees they charge clients for managing their investments, they naturally prioritize meeting client expectations. As a result, fund managers may unconsciously adopt a short-term mindset to avoid disappointing.

We know from previous discussions that focusing on short-term gains can hinder the long-term growth potential of investments. 

Restrictive Mandates

Naturally, clients are averse to money managers taking unnecessary risks, leading to the implementation of mandates which often limit the size of positions and the total exposure to industries or asset classes. Additionally, mandates usually require funds to be able to liquidate entire positions within a specified time frame.

Moreover, clients prefer managers to minimize cash holdings, as they would rather hold the cash themselves than remain idle in a fund charging them fees. So, even holding cash can be prohibited.

I have personally experienced this at my previous job. Our fund had an outstanding year, appreciating 66%. Because of the strong performance, we reduced our equity holdings as share prices increased, resulting in a cash allocation of over 30%. At this point, one of our largest clients questioned the high cash allocation, stating, “If we want to hold cash, we will hold it in our own bank account.”

Regrettably, we listened to them and reinvested in what we perceived as expensive investments at the time. Consequently, our performance was suboptimal in the following year.

So while these restrictions are reasonable from a risk management perspective, they inevitably constrain performance. 

Vulnerable to Client Behavior

Clients of funds exhibit the same emotional tendencies that drive all other investors.

There is a natural inclination to seek out fund managers who have recently outperformed, often assuming they are superior. However, this behaviour mirrors the “buying high” concept, which is flawed thinking. Rarely do these funds sustain their exceptional performance as they amass more capital.

When performance falters, clients begin to question their investment decisions and the competence of the fund manager, which, in turn, places significant pressure on the manager. If poor performance persists, clients may withdraw their investments often at the worst time, akin to “selling low.”

Moreover, market fluctuations can trigger panic among fund clients, prompting them to pull their investments hastily. These reactionary behaviors can undermine the fund’s stability, particularly if it leads to the forced sale of shares during unfavorable market conditions. 

Mimicking the Market

Due to the short-term focus, restrictive mandates, and fear of going out of business, managers often find themselves inadvertently copying the market so as not to disappoint. Consequently, the more they resemble the market, the less likely they are to outperform it.

The S&P SPIVA scorecard reveals that in 2023, only 40% of funds surpassed the S&P 500. However, over 10 years, a mere 12.6% of funds outperformed the S&P 500. It shows you just how challenging professional money management is, and part of the problem is due to the constraints.

While there are other shortcomings, these are natural hindrances that managers must deal with. Obviously, they are not issues you and I have; however, our real advantage over these managers stems from their size- the root cause of all three!

More Money, More Problems

Most money managers start with the noble intention of making money for their clients. They usually begin with a modest amount, and if they excel at their craft, they can outperform the market and their peers.

As their success grows, they attract more attention, and clients flock to them, hoping to capitalize on their expertise. Naturally, as professionals, managers accept more capital as it means higher fees and a more prosperous fund. It’s rare to find someone who turns down such offers.

However, a significant challenge arises as the fund’s size increases. With more assets under management (AUM), the fund’s investment opportunities diminish, leading to reduced performance. The larger the fund becomes, the fewer options it has.

For instance, while a $20 million fund can invest in almost any high-quality business,  a $20 billion fund faces limitations. It’s simply impractical for a $20 billion fund to purchase shares in a $200 million company as a 1% position means they own the entire $200 million business.

The larger the fund gets, the more it has to focus on larger, more established companies, and the more it starts to resemble the very thing it is trying to outperform – the index.

Advantage US!

Individual investors are not confined to the same restrictions as professional fund managers. We can invest in anything regardless of size. We can hold these for as long or as little as we want. If we choose not to invest, we can sit with the entire portfolio in cash without upsetting anyone.

But best of all, we can uncover high-quality businesses that institutional investors simply ignore. In the next section we’ll discuss how.

We’ve touched on how size gives you a significant edge over professionals. Let’s explore how to capitalize on that advantage. Enter my personal hero, Joel Greenblatt, and his book “You Can Be A Stock Genius”.

The Advantages of a Retail Investor

Despite its terrible title, “You Can Be A Stock Market Genius” is a gem of an investing book, which is easy to understand, regardless of your expertise in investing or accounting.

Mr Greenblatt eloquently elaborates, perhaps better than I have, on why individual investors possess an edge over Wall Street and introduces several techniques to leverage it. The book meticulously covers various corporate actions and explains how to seize the opportunity as an individual investor. This includes:

1.     Spinoffs

A spinoff is when a company decides to split off one of its divisions or subsidiaries into an independent entity by distributing shares of the new company to existing shareholders.

When this happens, Wall Street can ignore one of the entities purely because it is too small, which can lead to mispricing of that asset. Investors can benefit by owning the “forgotten” entity.

2.     Merger

A merger is the consolidating of two or more companies to form a new entity, aiming to achieve synergies, expand market presence, or diversify operations.

Mergers can lead to mispricing of either the company being acquired or the acquirer. Greenblatt shows you how to recognize the opportunity and capitalize.  

3.     Bankruptcies:

A bankruptcy occurs when a company can’t meet its financial obligations and seeks protection from creditors through legal proceedings.

The regulation around bankruptcies or liquidations can result in shareholders selling indiscriminately. We can benefit because distressed assets can become mispriced.

4.     Restructuring

Similar to bankruptcies, restructurings involve significant changes to a company’s organizational, operational, or financial structure to enhance efficiency, profitability, or competitiveness.

Individual investors can benefit as restructurings can lead to asset mispricing as institutions dump the stock.

5.     Rights Offering:

A rights offering is when a company want to raise additional equity, allowing existing shareholders to buy additional shares of a company’s stock at a discounted price, usually in proportion to their existing holdings.

Rights offerings are often harmful to existing shareholders as they dilute ownership. The astute investor can benefit by acquiring these rights at discount prices as others are “dumping” them. 

A Must Read

Joel Greenblatt managed a 40% return per year for over 20 years, which very few have matched. A large part of his success is because of the tools he teaches in this book. While it takes significant work to take advantage, those willing to put in the effort can become “a stock market genius.”

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