Broker Check

How the Smart Money Invests

| August 25, 2017
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When we think about investing prowess, many of us imagine outsized, market-beating returns from shrewd stock picking or market timing.  But that's fantasy; there's little evidence that professional investors can hand select tomorrow's winners or spot the impending bear market or bull-market recovery.  This doesn't mean, however, that all investors earn the same returns.  Not even close.  The "smart money" makes much higher, net-of-fee returns.

Consider two share classes of the Vanguard Value Index Fund.  The "Investor" share class is available to individual investors with as little as $3,000 to invest.  The "Institutional" share class is reserved for institutional investors who can meet the $5,000,000 minimum.  Now, if you put a lot of stock in the view that "expenses are all that matter," you would assume the actual returns earned by each investor cohort (individuals versus institutions) would differ by 0.14% per year -- that's the difference in expense ratios across the subclasses of the fund.  The reality is far different.

Indeed, the subclasses of the funds did experience 0.14% difference in returns (+6.34% vs. +6.50%) over the last 10 years.  But investor outcomes were far different.  Self-directed individual investors only earned +2.07% per year in "investor returns," which control for the timing of their buying and selling decisions.  Institutional investors fared far better -- gaining +8.04% per year, even better than the fund returns.

The main differences between individual investors and many institutional investors are that the former tend to invest based on recent past performance, hunches, and other arbitrary factors.  When performance turns sour (as it has for value stocks vs. growth stocks over the last decade), they often don't bother to stick around for the likely reversal.  Institutional investors, on the other hand, often design and manage investment portfolios by starting with an Investment Policy Statement (IPS).  They have a better understanding of long-term expected returns and are willing to sit through (and even rebalancing during) periods of disappointing performance.  This process-driven approach leads to better-realized returns, even on otherwise identical investments.

This is not to say that the "smart money" isn't concerned with expenses.  All things being equal, paying 0.14% per year less in fees is advantageous.  But the smart money realizes that avoiding a 1% to 2% a year (or, in some cases, over 4% a year!) cost from buying and selling at the wrong time is much more beneficial than small basis point differences (or reductions) in fees.  

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Past performance is not a guarantee of future results. Index and mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

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