institutional vs. individual investment decisions

This is a follow-up to my post from yesterday on perils of relying on an analyst’s investment recommendations.

The FINRA article I mentioned in that post comments that institutional investment decisions can be motivated by considerations that differ markedly from those we as individuals face.

What does this mean?  Here are some examples:

1.  for almost two decades, endowments (like those for universities) have made large investments in highly illiquid “alternative” assets.  They argue that their financial circumstances allow them to take liquidity risk in search of extra-high returns because they won’t need the money for, say, 25 years.

Such investments present several problems for you and me:

generally speaking, endowments haven’t cashed out of many of these investments, so it’s not clear how well they’ve done

we probably don’t have a 20-year+ investment time frame, and

we definitely will only be able to participate in alternatives on much less favorable terms than big institutions.  In retail-oriented projects, the organizers reap most of the rewards.

2.  An institution may try to offset the risk of “roll-the-dice” investments by being very conservative in other areas.  Without knowing its overall investment strategy, it’s hard to know how to evaluate any one part.  So when an institutional portfolio manager says he has a huge weighting in Treasury securities, it may be that he’s acting on instructions from his client, or it may be to offset the risk of holding a ton of risky emerging markets debt.

3.  Portfolio management is a craft skill that sometimes operates on less-than-obvious rules.  The IT sector, for instance, is the largest component of the S&P 500, making up almost 20% of the index.  The largest constituents are Apple, Microsoft, IBM, Google,  and Intel.

Let’s say I’m a PM and I don’t like the IT sector right now.  I probably won’t express my opinion by having no technology stocks.  To make up a number, I may elect to have 15% of my portfolio in IT.  If I’m right, I’ll make gains by having the “missing” 5% invested in a better=performing sector.  I may also decide that, because I want to be defensive in this area, I’ll shift my emphasis toward the biggest, lowest-multiple, most mature companies.


But that’s the point.  These will probably go down the least in a bad market.

As a result, I may end up having 3% of my portfolio in AAPL and another 3% in MSFT.  They may also be the largest holdings in my portfolio.  A cursory glance at my holding may give the impression that I like AAPL and MSFT.  I do, but only in the sense that I expect that they’d go down–they’ll lose less than smaller IT stocks, gaining me outperformance.   They’re my hedging alternative to making an all-or-nothing bet against IT.

Another situation:  let’s say I have no clue how AAPL will perform.  I may decide that I should concentrate my attention elsewhere in the portfolio, where (I hope) I can add value.  The easiest–and safest–thing I can do with AAPL is to neutralize it.  That is, I hold the market weight in the stock.  Yes, I won’t gain any outperformance this way, but I won’t lose any, either.  Because AAPL is the largest stock in the S&P 500, AAPL may end up being my largest position.  But, again, this doesn’t mean I like it.  It means I don’t want the stock to hurt me.

Will I explain any of this in an interview?  Yes, I’ll try.  But reporters’ eyes will glaze over.  What they’ll come away with is the idea they came in with–that my largest positions must be my favorites, and they’re AAPL and MSFT.




the FINRA Guide to Understanding Analysts’ Recommendations

Yesterday someone sent me a link to Understanding Securities Analyst Recommendations, written by the Financial Industry Regulatory Authority (FINRA), the brokerage industry trade organization.

The short article is surprisingly candid and contains important information, although couched in very abstract language.

The highlights (paraphrased by me):

–brokerage house analysts, and the brokerage houses themselves, are subject to enormous potential conflicts of interest when it come s to saying what they think the future performance of a given stock may be.  For instance, –a company may select a brokerage house for lucrative investment banking business based on how favorably the firm rates its stock

–conversely, it may refuse to give corporate information to analysts who rate the stock unfavorably.  The company may “forget” to return phone calls, avoid appearing at conferences sponsored by the analyst, refuse to appear with the analyst at public or private investor meetings, or not acknowledge requests for information from institutional investors that are directed through the offending analyst.  The company may even more overtly try to get the analyst fired.

–very large money management companies may build up gigantic positions in the stock of a given company.  Powerful portfolio managers may have large stakes riding on the stock’s performance–and the positions may well be too big to sell quickly, in any event.  So they may pressure brokers and their analysts to maintain a favorable opinion on the stock.  Their threat–to withhold trading commissions from a firm that downgrades the stock.  Same thing about firing the analyst, too.

–as a result, the terms brokers use to rate stocks may not be self-evident.  “Buy,” for example. may not be a particularly good rating.  “Strong Buy” or “Conviction Buy” may be what we’d ordinarily understand as”buy.”  “Buy” may be closer to “Eh” or “Hold.”  Of course, analysts may also have one official opinion in writing and another that it expresses verbally to clients.

Two other worthwhile points the article makes:

–some analysts may not be highly skilled, so their recommendation may not be worth much.  Rookies may not have enough experience, for instance, and they may be more susceptible to outside pressure than others.  Analysts may not know a spreadsheet from a hole in the ground but have the ear of management.  (Oddly, old-fashioned managements continue to give information to favored analysts that they deny to shareholders.)

–the fact that a portfolio manager owns a stocks, even if it’s a large position and if his analyst appears on TV saying positive things about it, the manager may hold the stock for completely different reasons (more on this tomorrow). Anyway, the FINRA page is well worth reading.