Institutional investors tend to make or break the market with their decisions, imparting a significant influence not only over asset prices but to the overall sentiment towards these investments. To that end, should retail investors simply follow institutional investors for financial success?
In April, Warren Buffet decided to offload pandemic-stricken airline stocks, and this led others to follow his footsteps. Hence, a sharp selloff sent airline carriers’ shares lower, and confidence in the sector diminished. It made sense for the typical retail investor to apply the same methodology of an institutional investor as influential as Berkshire Hathaway.
However, in less than a month, Wall Street realized that Buffet made a mistake in closing his positions on airline stocks, as the market boomed and led to a nearly 100 per cent rally in airline shares. Consequently, the retail investors who followed Buffet’s decision made a big loss during the selloff and missed the opportunity of making profits during the boom. This incident raised the question about the validity of retail investors imitating institutional investors.
Never a sure shot
Institutional investors have highly experienced analysts alooking for the best market opportunities. These fund managers make multi-million-dollar investment decisions for clients and spend a considerable amount of time gauging the profitability of these as per their understanding of the market’s price action. Nonetheless, this does not ensure that any position they open may, by any means, fit retail investors, as they build their decisions on various factors.
Casting about
Large institutional investors have complex investment strategies, such as trading on multiple and correlated assets, and hedging forex risk exposure. They base these strategies on their expectation of market behavior, aimed at long-term growth. On the other hand, most retail investors trade without a clear plan, and some try to mimic the large investors’ positions without having any background on the logic behind these decisions.
Sovereign wealth funds, for instance, make some of their investment decisions while taking into consideration local governments’ politics and socioeconomic aspects. This may include investing in international companies with a promise of bringing job opportunities to the local market to reduce the unemployment rate, or due to a government-led decision to diversify away from certain assets.
A prime example of this trend is the Public Investment Fund of Saudi Arabia’s recent decision to exit their positions on individual stocks last month, as they made a strategic decision to focus on investing in Exchange Traded Funds (ETFs), primarily in the real estate and utility sectors. As such, retail investors can make knee-jerk reactions to institutional changes on this scale, resulting in rash decisions that may negatively impact their portfolios.
Advantages, but...
The prominence of these institutions, sheer volume of their resources, and their ability to access a large network pose significant advantages over retail investors with limited information and expertise. Nonetheless, institutional investors’ strategies may not be always superior to that of retail investors, considering variant and unprecedented market conditions, such as financial crises.
The pandemic has undoubtedly incited a wave of market behaviors that have not been seen before this crisis. The dynamic between institutional investors and capital markets is not exempt from this. A study published by the University of Virginia and the University of Zurich shows that US stocks with higher ownership of institutional investors - specifically those held more by active, short-term, and domestic institutions - performed worse than their counterparts during COVID-19.
This suggests that both retail and institutional investors have to adapt to the everchanging market conditions.
As such, retail investors must be cautious when copying large institutional investors’ strategies and perform the necessary due diligence before using them. Analysis by financial institutions on a particular asset or industry is often available publicly, which can be useful for retail investors to make their decisions.
- Madalina Rotaru is CEO of CAPEX.com.
