A Market Edge: Individuals against Institutions

Bad news first: when individual investors compete against institutions, then the institutional players have the advantage on their side. We must face uneven odds from the get go, because we can’t help but invest in the same market place as the big boys.
Such unfavorable base rates are something I try to avoid as much as possible: I would much rather sail with the wind in my back at the outset.

But maybe, we can find ways to turn a negative base case to our advantage?

A closer look at institutions

Large institutional investors play a big role in the market place and warrant closer scrutiny as they trump individual investors with more and better informational and analytical resources at their disposal – leading to a general advantage. 

In a thorough analysis of the Taiwan stock market during the 1990s this performance gap for active, individual traders amounts to an enormous 5,3% annually.

Chart from “Who Is On The Other Side?” a paper by Michael Mauboussin

Gaining an active edge by analyzing institutional investors

On the other hand analyzing institutional investors can lead to significant edges, because they are often constrained in their action by rules and motivations that have nothing to do with an effort to outperform. 

Many sustainable ideas are hidden in places where institutions are acting predictably:

  • Professional investors are forced to act in a certain way:
    Downgraded corporate bonds: forced institutional selling depresses prices artificially and makes bonds downgraded to junk status an outperforming investment on average, because many institutional mandates are not allowed to hold low-grade bonds.
    Index funds track the index mechanically: the price of stocks that are added or deleted from indices are predictably distorted. Size constrains prevent big players to take advantage of this anomaly as it mainly plays out in a small number of depressed stocks that are leaving an index.
    Market makers create predictable flowsdealer gamma exposure has gotten a lot of attention since option volumes relative to the underlying market have grown significantly. Their hedging activity represents a predictable part of the demand and supply that changes price levels in the market.
  • Managers are unwillig to be different
    Failing conventionally may be preferable to succeeding unconventionally, because this entails the risk to fail unconventionally which might cause the manager to lose his job.
    Any edge that stays close to the overall market is likely to be arbitraged away by sophisticated competition. A good example is the recent prevalence of quantitatively, tilting a market portfolio to certain factors in an effort to outperform while staying correlated to market beta. Such „Smart Beta“ strategies have shown a shrinking advantage (often even a reversal of results, e.g. the value factor) in the years since they became a mainstay of institutional investors.
    A willingness to be different is key when looking for an edge that exploits professional constraints.
  • Areas where institutions do not tend to go
    Size constraints: many viable trading strategies are the domain of small traders, because it is impossible to trade them at large scale. Thus bigger players ignore them, because they are simply not worth the effort.
    Time horizons they are not judged on: the period between high frequency trading and several weeks is a good place for small, flexible traders to look for an edge. Many professionals are judged on their quarterly performance and concentrate their portfolio composition looking out three months or longer. Large portfolios cannot simply be turned over in an instance as small ones can.
    Concentrated portfolios: few money managers can afford to take highly concentrated positions without risking scrutiny by their investors. Exceptional opportunities are often too small to make up a large part of a big portfolio. 

The passive solution

An easier way to negate the institutional advantage is to simply accept market returns by investing in index ETFs. The outperformance over individuals is relative as very few institutional investors beat the market over long time periods. They still lose to the market, just less so than retail investors.
By refusing to play the active investing game individuals can come out ahead.

The simplest edge still is the passive edge. Performing in-line with the market average is easily underestimated – both in its power to deliver returns (through steady compounding) and how rarely it is actually achieved by investors in practice.
Very few individuals manage to stick with it over the long term, because it is so painful at times. Numerous studies have shown that most investors (retail and professional alike) underperform the market, because we instinctively chase good performance and panic-sell when the pain of losing becomes too strong – causing a behavior gap by effectively buying high and selling low.

A lot of this underperformance is caused by being underinvested for a long time after being scared out of stocks in a bear market.

I think, this is the best opportunity for the stoic individual. Simple, automated rules can enable anyone to participate in economic growth, if we manage to ignore the market and the path our investments take in the short run. Inattention can be an edge.

Of course this widespread underperformance also implies, that not only does a small minority actually achieve average market returns, but also that a select few investors must capture the remaining outperformance.  

Good luck with your investments & thank you for reading!


Browse Recent Blog Posts

If you like what you are reading, please consider subscribing – thank you!

One comment

Leave a Reply