The Pros And Cons Of Institutional Ownership

By Glenn Curtis AAA

Because institutions such as mutual funds, pension funds, hedge funds and private equity firms have large sums of money at their disposal, their involvement in most stocks is usually welcomed with open arms as their vocal interests are often aligned with shareholders. However, institutional involvement isn't always a positive thing, especially when the institutions are selling.

As part of the research process, individual investors should peruse 13D filings (available at the Security and Exchange Commission's website) and other sources to see the size of institutional holdings in a firm along with recent purchases and sales. Read on for some of pros and cons that go along with institutional ownership that retail investors should be aware of.

Pros of Institutional Ownership
Smart Money Involvement
Portfolio managers often have teams of analysts at their disposal, as well as access to a host of corporate and market data that most retail investors could only dream of. As such, they are able to perform in-depth analyses.

Does this guarantee they'll make money in the stock? No. But it does greatly enhance the probability they will book a profit, and may put them in a better position than individual investors. (To learn more, read Institutional Investors And Fundamentals: What's The Link?)

Institutions Market the Stock
After some institutions (such as mutual funds and hedge funds) establish a position in a stock, their next move is to tout the company's merits to the sell side. Why? The answer is to drive interest in the stock and boost the value of the share price.

In fact, that's why you see professionals such as top-notch portfolio and hedge fund managers touting stocks on television, radio or at investment conferences. Sure, finance professionals like to educate people, but they also like to make money, and they can do that by marketing their positions much like a retailer would advertise its merchandise.

Once a institutional investor firm establishes a large position, its next motive is typically to find ways to drive up its value. In short, investors who get in at or near the beginning of the institutional investor buying process stand to make a lot of money. (For more insight, see What is the difference between a buy-side analyst and a sell-side analyst?)

Institutions Can Be Good Citizen Shareholders
Institutional turnover in most stocks is quite low. That's because it takes a great deal of time and money to research a company and to build a position in it.

In any case, when funds do obtain large positions, they want to do their utmost to make sure their investments don't go awry. To that end, they'll often maintain a dialogue with the company's board of directors, and look to acquire stocks that other firms might want to sell before they hit the open market.

While hedge funds have received the lion's share of attention when it comes being considered "activist", a number of mutual funds have ramped up their pressure on boards of directors as well. For example, Olstein Financial generated a lot of press, particularly in late 2005 and early 2006, for peppering several companies, including Jo-Ann Stores, with a host of suggestions for driving shareholder value like suggesting to hire a new CEO. (For more insight, see Activist Hedge Funds.)

The lesson that individual investors need to learn here is that there are instances when institutions and management teams can and do work together to enhance common shareholder value.

Cons of Institutional Ownership
Fickleness Can Kill
Investors should understand that although mutual funds are supposed to focus their efforts on building their clients' assets over the long haul, individual portfolio managers are frequently evaluated on their performance on a quarterly basis. This is because of the growing trend to benchmark funds (and their returns) against those of major market indexes such as the S&P 500. (For more insight, see Is Your Portfolio Beating Its Benchmark?)

This process of evaluation is quite unfortunate because often what happens is that if a portfolio manager is having a bad quarter, he or she will dump underperforming positions (and buy into companies that have trading momentum) in the hope of achieving parity with the major indexes in the following quarter. This can lead to increased trading costs, taxable situations and the likelihood that the fund is selling at least some of these stocks at an inopportune time. (For more on this, see Why Fund Managers Risk Too Much.)

Hedge funds are also notorious for placing quarterly demands on their managers and traders. This however, is due less to benchmarking and more to the fact that many hedge fund managers get to keep 20% of the profits they generate. In any case, the pressure on these managers and the resulting fickleness can lead to extreme volatility in certain stocks; it can also hurt the individual investor who happens to be on the wrong side of a given trade.

Selling Leads to Excess Supply
Because institutional investors can own hundreds of thousands, or even millions, of shares, when an institutional investor decides to sell, the stock will often sell off, which impacts many individual shareholders.

Case in point: When well-known activist shareholder Carl Ichan sold off a position in Mylan Labs in 2004, its shares shed nearly 5% on the day of the sale as the market had to absorb the shares.

Of course, it is impossible to assign the total value of a stock's declines to institutional sales. The timing of sales and concurrent declines in those share prices should leave investors with the understanding that large institutional selling does not help a stock go up. Also, the sales are often a harbinger of things to come, due to the access and expertise of these institutions - remember they all have analysts working for them.

The big lesson here is that institutional selling can send a stock into a downdraft regardless of the underlying fundamentals of the company.

Proxy Fights Can Hurt Individual Investors
As mentioned above, institutional activists will typically purchase large quantities of shares and then use their equity ownership as leverage to obtain a board seat and enforce their agendas. However, while such a coup can be a boon for the common shareholder, the unfortunate fact is that many proxy fights are typically long, drawn out processes that can have an adverse impact on the underlying stock, as well as the individual shareholder.

Take for example what happened at The Topps Company in 2005. Two hedge funds, Pembridge Capital Management and Crescendo Partners, each with a position in the stock, tried to force a vote on a new slate of directors. Although the battle was eventually settled, the common stock lost about 12% of its value during the three months of wrangling between the parties. Again, while the full blame of the fall in share price can't be placed on this one incident, these events don't help share prices move up because they create bad press and often force executives to focus on the battle instead of the company.

Investors should be aware that although a fund may get involved in a stock with the intention of doing something good, the road can be difficult and the share price could, and often does, wane until the outcome becomes more certain.

The Bottom Line
Individual investors should not only be aware of which firms have an ownership position in a given stock, but also of the potential for other firms to acquire shares and reasons that a current owner might liquidate its position. Institutional owners have the power to both create and destroy value for individual investors. As a result, it is important that investors keep tabs on and react to the moves the stock's biggest players are making.

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