I recently had the chance to talk with Aaron Watson on his podcast, Going Deep with Aaron Watson. We touched on a lot of different topics, including the writing process, networking and investing. We also talked about the institutional investment industry. Aaron asked me what I thought some of the similarities and differences are between individual and institutional investors.
In my book I quoted Yale’s David Swensen on this topic:
The most important distinction in the investment world does not separate individuals and institutions; the most important distinction divides those investors that have the ability to make high-quality active management decisions from those investors without active management expertise. Few institutions and even fewer individuals exhibit the ability and commit the resources to produce risk-adjusted excess returns.
Many “sophisticated” investors assume that because they have larger pools of capital that there’s a need to make things overly complicated. It took me some time to come to this realization, but from a portfolio management perspective, more money just means a couple more zeroes.
Whether you’re an individual with a small brokerage account or a multi-billion dollar pension plan, you still have to consider your risk profile and time horizon(s) when making investment decisions. You still have to understand your liquidity needs as well as your willingness, ability and need to take risk. And you still have to make sure you’re invested in a way that suits not only your goals, but also your personality, resources, time constraints and understanding of the markets. Every portfolio has a liability or need to meet.
While the strategy will certainly be different depending on the individual or organization, the philosophy doesn’t have to change. There are other differences and challenges faced between the institutional and individual investor. Here are a few:
The decision-making process. The biggest difference between institutional and individual investors is the fact that institutions are overseen by committees. You’re likely dealing with a board of directors along with an investment committee within the board who oversees the consultant, advisor or investment team who is running the portfolio. This group dynamic can be very difficult to manage when you have competing interests, personalities and ideas. Communication, implementing the right investment plan and setting the right expectations is very important in this setting. Individuals don’t have to worry about decisions-by-committee.
Resources and access. Institutions can employ financial professionals to oversee nearly all aspects of the day-to-day management of their portfolio. They can hire in-house or outsourced experts who can provide a wide variety of services. Retail investors are on their own, although the Internet has leveled the playing field somewhat in terms of research, data availability and market analysis.
Taxes. Pensions, endowments, foundations and other non-profits pay no taxes. This is a huge advantage for these funds in terms of the types of strategies they can employ because the Uncle Sam can take a huge bite out of a hyperactive strategy. The problem is many of these funds see this as a green light to constantly change their investment stance, which has costs of its own. For individuals, tax efficiency can be a huge advantage, but taxes will still hurt your bottom line at some point no matter how efficient your strategy.
Benchmarking. Institutional investors are very benchmark-oriented. They track each individual manager, asset class and the overall portfolio to a specific index or composite benchmark. Institutions also spend far too much time worrying about their peer rankings. Obviously, investors have to monitor their performance but many of these funds take things too far and forget about their own goals when framing every decision in terms of how their portfolio performed against some benchmark over the last month or quarter. Intelligent investors understand the the most important benchmark is whether or not you’re on track to achieve your stated goals and objectives.
Costs. Because of their size, institutional investors have the scale to command lower fees from banks, investment managers and trading platforms. Unfortunately, many squander that scale and willingly overpay for funds and services in hopes of hitting it out of the park. ETFs and improvements in technology have leveled the playing field on this one as individuals can now invest for pennies on the dollar in an ever-growing mix of investment products.
Product availability. There are some investment structures and products that institutional investors see before anyone else because they have so much capital. By the time things like hedge funds, private equity or fund of funds reach the retail level these products are likely littered with extra fees and second-hand investment strategies that the large investors have already passed on.
While institutions have many advantages over the little guy, they often squander these opportunities by defaulting to a complex investment posture or short-term thinking. Individual investors have plenty of advantages over some of the biggest funds in the business:
- You have the ability to think and act for the long-term with no short-term pressure from a committee or your investors.
- There’s no career risk to worry about.
- You can worry exclusively about your own personal situation and ignore any outside distractions.
- No one will judge how you invest as there is no one to impress.
- You don’t have to worry about “beating the market” or your peers.
Listen to my interview with Aaron here for more:
Going Deep With Aaron Watson
Further Reading:
My Next Step
Time horizon is one I often hear. I don’t really think this is all that different as both the average institution and the average individual have both short term (1-5 yr) and long-term (15+ yr) concerns. Thoughts?
Depends on the institution. Foundations/Endowments technically have an infinite time horizon. Time horizons for pensions depends on the age of the workforce/the need to meet liabilities (withdrawals). Life insurance and P&C companies have different time horizons depending on their future expected liabilities.
For individuals, it all depends on which stage you are in (pre-retirement, retirement phase, post-retirement, etc.). There’s a lot to consider.
It’s not necessarily the length of the time horizon, it’s being able to actually invest for that time horizon without getting scared out of your long-term holdings. Far too many short-term decision with long-term capital at stake because of career risk and overconfidence.
I was an advisor for a private equity firm for a couple of years and one of the big selling points they loved to push on individual investors was the fact institutional entities are large holders of PE, thus it would be wise for an individual to mimic the portfolio structure of these successful mega-funds.
I found this to be very faulty logic for a couple of reasons. The first, as already mentioned, is the individual finite vs institutional infinite time horizon. For instance, the Canadian Pension Plan, one of N.Americas most active PE entities, has a large PE allocation but also a 70-year investment model.
The second is, as Ben mentioned, institutions have the capital resources to put them first in line and providing much different risk and return than the late-entry retail investor. Institutions also have exposure to international opportunities when individuals are most likely bound to domestic private equity deals.
It’s kind of like saying because the government operates with deficits and debts, so should the household.
Bottom line, individuals are not institutions.
Yup and people forget how long it can take to build a diversified PE portfolio.