What’s you competitive advantage (in investing) ?

There is a very interesting post at the (higly recommended) Psy-Fi blog about the general chances of small investors against institutional investors.

They compare it for short term trading to the “Sanzibar war”:

In terms of competitive advantage private investors engaging in short-term trading against financial institutions is the greatest mismatch since the Anglo-Zanzibar War of 1896 which lasted only 45 minutes – and which ended with the British being paid for the shells they’d fired into their opponent’s country.

They also correctly mention privileged information from companies available for institutional investors:

We find significant increases in trade sizes during the hours when firms provide off-line access to investors, consistent with off-line access providing selective access advantages. We also find significant increases in trade sizes after the presentation when the CEO is present, consistent with CEO meetings providing selective access advantages. … Finally, we find significant future absolute abnormal returns after the conference for firms providing off-line access, suggesting such access is potentially profitable for investors. While we cannot conclusively state that managers are selectively disclosing new information outside of the presentation, our evidence does suggest that investor conferences confer a selective access advantage on the buy-side investors that have been invited to attend.

Additionally they think that private investors ar much less likely to exploit statistical anomalies:

The ability of the securities industry to automate trading to capture the abnormal returns from any anomaly in the market (Pricing Anomalies, Now You See Me, Now You Don’t) means that anyone attempting to out-compete them is facing the hopelessly overwhelming odds of the Zanzibar Effect and, like the hapless Zanzibarians, paying them for the privilege.

So should we just stop messing around with managing our own money and hand over our hard earned money to the institutions ?

Psi Fi offers some hope: They stress that small cap investing with a longer time horizon could be one way to beat the institutions:

Our competitive advantages are elsewhere; the Law of Big Numbers dictates that smaller companies simply aren’t big enough to justify lots of institutional analysis, so the asymmetric informational advantages often lie with private investors prepared to put in the effort. One reader noted that he invests in smaller French companies because the reporting language rules out a lot of competition. Nor are private investors constrained to make quarterly or annual returns – we can buy companies with good business models but which are temporarily distressed and wait. Or we can make sure we’re ready to supply liquidity to the markets when institutions are forced to give it up in one of their once a decade panics.

I fully support their arguments, but I think in addition to long term contrarian small cap investing , private investors have much more advantages than they are aware of.

1. Asset class restrictions

Most asset managers are restricted to certain asset classes. Many large institutions (pension funds, insurance companies) employ either consultants or own employees who are supposed to be great allocators acrosss asset classes, leaving actual money managers with very narrowly defined mandates for only small sub sets of the investment world.

Anyone with some institutional knowledge can tell some stories how the supposedly superior asset allocation process works: Money almost always goes into the historically best performingasset classes which is the dominant “cover your ass” strategy in this area.

As a private investor, you have a big advantage here : you are not restricted at all. You can look at stocks if they are cheap, or bonds if they seem to be a better choice. In 2008 for example, it was relatively clear that the risk/return of subordinated financial bonds were much better than owning stocks. However as a typical stock portfolio manager you were not allowed to buy bonds.

In my opinion, this is also one of the underappreciated competitive advantages of Warrent Buffet’s Berkshire set up. Despite the whole “moat” thing, his structure allows him for instance to go to “pref shares + options” type of trades as well a selling options, buying distressed debt etc.

2. Instrument restrictions

Many money managers are further restricted with regard to instruments they can buy. So either they can buy only stocks or only bonds or only convertible bonds, but few can freely decide what instrument tob uy.

The best current example for this are currently in my opinion the now closed former open ended German real estate funds. I do not know any institiutional mandate which would allow this kind of investment.

The German Insurance regulation for example explixitely does not allow insurance companies to invest in open ended funds which have stopped taking back shares, meaning that if you owned them before they have closed, Insurance companies were forced to sellt hem.

So being abletoinvest in any instrument as aprivate investor,in my opinion opens up a lotof very attractive risk / return scenarios.

3. Reputational risks

As I mentioned in point 1., a lot of the activities in institutional asset management is based on “cover your ass” strategies. For every portfolio manager it is much easier to talk to his bosses, clients or to attractive persons on cocktail parties about “great” companies one owns and manages. If thegreat company turns out to be a not so great investment, this gets attributed very rarely to the money manager.

It is much harder to explain why one owns subordinated bonds of banks under Government control, shares in now closed investment funds or “obscure” Italian companies, where everyone knows from “Bild” that Italy goes down the drain. Many people think that those “special situations” are much riskier than the “great and easy to explain” investments andthis is exactly why they are often much more interesting from a risk return point of view.

4. Size & Control of funds and liquidity premium

As an institutional money manager, one has the following two problems if one wants to exploit illiquidity premiums:

a) you do not control in and outflows of money. So if you think a relatively illiquid market segment is an interesting opportunity and you invest, suddenly the clients wants out and you have to liquidate your positions at great losses. So even if you have a long time horizon as an institutional money manager personally, your time horizon in reality might be much shorter. This is by the way the second “institutional” feature which is in my oninion very important to understand Warren Buffet’s success.

b) many times, size is an issue. Even with my “modest” 10mn EUR virtual portfolio, I find it hard to enter and exit into smaller but interesting situations. For a 1 billion portfolio, it just doesn’t make a lot of sense to research a potential 1mn EUR investment which leaves a lot of ideas unexplored.

So summarizing this whole post, I would conclude the following:

For individual investors, the freedom to invest in any asset class, in any type of instrument, regardless of name, country of domicile and size creates a significant competitive adavantage to institutional money managers.

Combined with the control of the funds and a long time horizon, in my opinion this is almost unbeatable by any traditional money manager. Only money managers who manage to overcome those limitations (Berkshire, Private Equity funds, Hedge funds, family offices) can come close.

IMPORTANT: It is not a guarantee to outperform. There are many bad investments, value traps, frauds and semi-frauds out there, but mostly they can be avoided through thorough due dilligence and common sense.

2 comments

  • Jan,

    that is true.In addition you willbe constantly critisized by “risk managers” etc. why you tae such “big risks”.

    In an institutional environment It is much safer to invest for instance into the China story.

    mmi

  • Very true.

    Especially the issue of time arbitrage crossed my mind recently in the case of Italian stocks. Even if you believed that Italy stays in the Eurozone, the expected short term pain might discourage you from buying Italian stocks although you might regard them as cheap.

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