The 1990s marked an era of individual investing, with mutual funds as the bright stars. A decade or so later, though, these popular investments are losing their luster. They are coming up short as the way to achieve financial goals for so many individuals. And businesses, challenged to be competitive in tight markets today, must look elsewhere.
In a conversation I had recently with Robert Briant, CEO of NJUTCA, I learned that the utilities and transportation construction industry also is facing some of those challenges. He agreed that smart investment strategies are becoming critical to maximizing profits and improving cash flow.
But what's the best financial solution for you? Do you rely on investments in no-load funds that are providing less than stellar performance? Institutional funds are well worth considering. These funds are far more lucrative than retail funds, yet they are far less understood.
Institutional vs. Retail: A Comparison
Institutional money managers are found at independent financial advisory firms. The institutional investor has typically been an individual or organization that trades securities in large enough share quantities that they qualify for preferential treatment and lower commissions.
But institutional asset classes, once beyond the reach of all but the wealthiest and largest investors—such as pension programs and financial institutions—are now available to many more investors today. You can gain the same advantages that these large investors previously received.
Retail money managers, on the other hand, are typically found in the mutual fund industry (such as Fidelity and Vanguard), the brokerage industry (such as Charles Schwab and Merrill Lynch) and the insurance industry (such as Transamerica and Manulife). Retail investors can be individuals with as little as $500 to invest.
Perhaps the best way to analyze the two types, retail and institutional, is to look at how they operate. For retail funds, their charter allows them to invest in any securities, anywhere, anytime. A "growth" fund, for instance, might purchase some large company stocks, micro caps, emerging market stocks, a few convertible bonds, and a bank in the Far East. The question is: can a manager know enough about semiconductors, automobiles, foreign banks and consumer goods to effectively select the best stocks?
No-load funds are the hallmark of retail investing. But many of these funds have expense ratios (annual internal expenses) of close to three percent. These costs do not include trading expenses. In addition, the overhead is higher at retail organizations, and includes costly advertising and other promotional expenses. Imagine what it takes to provide a $500 account with an annual prospectus and quarterly reports. These costs are priced into the fund's expense ratio.
Institutional accounts are characterized by four key attributes—
1. Lower operating expenses We know that all mutual funds and separately managed accounts have expenses, such as management fees, administrative charges and custody fees, expressed as a percentage of assets. According to Morningstar, however, the average annual expense ratio for all retail equity mutual funds is 1.54 percent. In comparison, the same ratio for institutional asset class funds is typically only about one-third of all retail equity mutual funds. Lower costs lead to higher rates of returns.
2. Lower costs due to lower turnover Retail mutual fund managers consistently trade more often than institutional, thinking this adds value to the investor. But consider that if a mutual fund has a turnover ratio of 83 percent, that means 83 percent of the securities in the portfolio are traded over a 12-month period. This is costly to shareholders, with more transaction costs, including commissions, spreads and market impact costs.
If the fund trades heavily, or invests in small company stocks for which trading costs are very high, these hidden costs may amount to more than a fund's total operating expenses.
3. Lower taxes due to lower turnover If a mutual fund sells a security for a gain, it must make a capital gains distribution to shareholders because mutual funds are required to distribute 98 percent of their taxable income each year to stay tax-exempt at the corporate level. They distribute all their income annually because no mutual fund manager wants to have his or her performance reduced by paying corporate income taxes.
Because institutional asset class funds have lower turnover, they have significantly lower taxes.
4. Consistently maintained market segments Most investment advisors agree that the greatest determining factor of performance is asset allocation-how your money is divided among different asset categories. However, you can only accomplish effective asset allocation if the investments in your portfolio maintain consistent asset allocation. That means your funds need to stay within their target asset classes.
Institutional money managers typically are rated and identified by their respective management styles. They consistently focus on their stated investment policy, goals and objectives. They avoid "style drift," which happens frequently with retail funds and can lead to poor long-term performance results.
Not surprisingly, institutional managers are typically under greater regulatory scrutiny, and also under scrutiny as to their investment performance returns and portfolio risk due to the level of clientele served.
Since few institutions would put up with lack of focus or style drift, institutional money managers have a reputation of always following the asset allocation decisions of their investor's investment policy. Moreover, institutions demand that their investment managers display no harmful trading practices.
Retail managers, on the other hand, cater to the broad-based consumer, and generally provide generic ideas of how much risk someone should take. Unlike institutional managers, these managers are not typically supported by teams of experts looking after the client's specific financial interest.
The bottom line is that retail managers have a history of sub-par performance in that 80 percent of all mutual funds cannot equal the performance of the national averages, such as the Dow Jones or S&P 500. Institutional asset classes have consistently proven superior and now account for 70 percent of all trading activity.
Institutional investing may not be the answer for everyone, but may be the surest way to achieve your financial goals and ensure profitability for your business.