The Dilemma Of Fund Managers With Large Institutions

By Lawrence

The Dilemma Of Fund Managers With Large Institutions. DaytradingBias.comMajority of long term funds (i.e. not hedge funds) are all under performing the S&P 500 for 4 to 5 years in a row. Many people are expressing frustrations against the fund managers while some others are having fun making jokes about them. I guess it is not a bad time to explain why in long run majority of these fund managers must underperform broad based market indices.

The Burden Of Size

The opinions of the biggest fund managers matters. Their opinions as a group can drive the stock markets in one particular direction, the upside, for a long time. The reason is actually quite simple. They are the ones who step in when the stock market looks worst to absorb the liquidity. They may not be able to stop the S&P 500 index from falling immediately, but their actions as a collective group over a period of time will produce a longer term bottom for the stock market.

Individual traders probably do not understand why these fund managers have to buy before a market bottom is in place. Why not buy after a confirmed bottom is in place, as I advocate all the time for individual traders?

The short answer is that they cannot because they are the one who created that confirmed bottom for you, the retail traders.

The long answer is that they cannot because when the stock market already turnaround, there will not be enough offers in the market for them to buy any more. These fund managers cannot wait for their peers to do the job first. As a trader, you need sellers willing to sell at a price point where it is acceptable to you, as a buyer, to make the transaction happens. For fund managers with large institutions, you need many sellers to give you the shares you want.

The Dilemma Of Buying Low

As these fund managers cannot just buy at a particular price point, they are forced to step in and average out the cost of their positions. In other words, they can never get the best price possible in any individual position.  Their costs are always above that all time low you may have the guts to step in and buy with your friends on the stock you think that is hitting a bottom.

Thus, even if these fund managers picked the right stocks to own, they will still be clipped a few percentage on their entries. There is nothing they can do to completely remove that disadvantage. If they waited for a bottom to be in place first, then their average cost will be even higher as they have to chase the stock while it is rising quickly.

In a market environment where individual stocks in many sectors are performing significantly better than their peers, a good fund manager will have the chance to outperform the broad based market indices because picking the better individual issues counts.

In a market environment where the better stocks are all concentrated in the indices already, these fund managers will have a very hard time to beat the indices as they can never get the best possible price in anything nor can they find winners that can outperform their peers significant enough to offset the entry disadvantage.

The current S&P 500 is in such an environment right now because it is what matured industrial companies are in a global economy. Many of these companies are there as part of the global infrastructure. These matured competitors within the same industry are not there to play cutthroat business. They are there to maintain their turf and profitability. Hence, we are in a stable non-competitive environment where the price of the individual stocks are detached from the performance of the businesses.

The Dilemma Of Selling High

Large funds cannot unload all their holdings quickly. They cannot even unload an individual issue all in one day without disrupting the stock price significantly. Thus fund managers are forced to do all kinds of massaging of their positions to extract profits without rocking the boat.

Similar to the problem with buying stocks at best possible price, large fund managers cannot sell at the best possible price in majority of their holdings. They can choose to reduce their position size but selling too many shares of an individual issue in a short period of time may induce others selling too. The result will be even lower price level for the issue that the fund manager is still holding. That means lower fund valuation at the end of the day.

As the metrics used by most fund managers are now pretty much the same, their evaluation of the individual stocks are about the same. Thus a large fund manager who wanted to unload all the shares of a particular stock will have a hard time finding someone else to unload to. Remember that it is not feasible for them to sell at market like a retail trader. If they do, the average exit price will be significantly lower than the price where they wanted to unload at.

Another catch 22 for these fund managers to deal with and there is absolutely no solution to the problem.

The Panic Sell Button

The nightmare of any fund manager is answering a burst of fund redemption calls.

When a portion of clients react to news shocks or market driven events by calling in to redeem at the same time, the fund managers are forced to unload stocks quickly to raise enough cash to meet the redemption requirement. There are rules and regulations the fund managers have to follow. Hence, they are forced to sell a portion of their holdings probably at the worst possible time if the event that induced the panic calls is a one time shock.

This forced selling among many funds can induce further deterioration in the stock prices. As the situation gets worse, say, the original event was not a one time incident, waves of redemptions will start. The fund managers will be forced to sell more of their holdings at any price they get.

Panic selling seldom happens at the end of the year. Hence, the stock market would have time to recoup for the end of year evaluation. At this point in time, however, many large funds are hit badly by the redemption selling already. Even with the remaining holdings bounced back up somewhat, the performance for the year will be affected negatively.

Summary

The only advantage a large size long term fund has is the ability to pick many star performers from the large cap stocks. Given that the size of each individual issue they hold are restrict to certain percentage of their funds to avoid dependency, without the environment allowing for multiple star performers to emerge from the global economy, these large size funds are destined to mediocre performance as they cannot overcome the structural disadvantage they inherited from their size.

There was a period of time in the past where the large fund managers could still outperform the broad based market indices. That was the time when globalization just started. We are way past that period now.

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