Confessions of an Institutional Investor

[zarley]

Josh Brown reproduces a note he got from an institutional investment advisor regarding the mentality of institutional clients.  Interesting perspective on the forces driving the investment of huge pools of capital.  One might think that illiquidity and high fees would make some of these "investments" non-starters, but it doesn't seem so.

 

http://www.ritholtz.com/blog/2013/12/confessions-of-an-institutional-investor/

 

So why do most institutions in invest this way?

 

1.  It’s Interesting

 

What sounds more stimulating as an allocator of capital?

 

a) Traveling to New York, Silicon Valley and London for “due diligence” trips to meet with hedge fund, private equity and venture capital managers, getting wined and dined with free food and booze while getting to hear about complicated strategies, alpha, new technologies and ‘what sets us apart.’

 

or

 

b) Finding undervalued asset classes, markets and sectors at a low cost, to achieve a broad diversification and earn multiple streams of beta. You can imagine why most institutional investors choose option a). Don’t get me wrong, these trips are a great perk of the job, but I’m not sure how valuable they are for the organization.

 

2.  They Think It’s Their Job to Outperform

 

Most institutional investors assume, “My job is to outperform the markets or my benchmark and earn a performance bonus.”  This is the wrong way to look at a portfolio.  Setting a broadly diversified asset allocation, making good decisions, rebalancing to undervalued assets even when it doesn’t feel right, reaching the goals of the organization, reducing fee drag, ensuring liquidity for short-term needs and remembering your time horizon and risk profile should be your job.

 

You can add value without constantly searching for uncorrelated alpha with low downside volatility.

 

The boards at most pensions, endowments and foundations don’t help either.  They all go right along with the herd mentality.  Most are very successful in business, ultra-competitive and want nothing more than to beat the performance of Harvard and Yale.  Everyone wants to beat everyone else even with different agendas and somehow complex becomes the norm.

 

3.  They Assume Complex Must be Better

 

The investors that run these portfolios are highly educated individuals who are very intelligent.  It’s hard for them to admit that the simple solution makes the most sense.  Being able to understand complex strategies makes them think they are superior to index funds and ETFs.  There is false sense of security when you spend your time talking with brilliant, wealthy alternative managers.

 

I’ve been in a number of meetings with active managers or consultants who have said the only clients they have lost left to invest with index funds.  They wear this fact like a badge of honor.  Everyone shares a laugh at the poor investors earning low-cost, market returns.  They fail to acknowledge study after study that proves index fund superiority.

 

The author might be painting with a broad brush and projecting the decisions of a few onto the whole; but it rings true to me in a lot of ways.  Interesting read.