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 vocally expressed interests are often aligned with those of smaller shareholders. However, institutional involvement isn't always a good 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 the pros and cons that go along with institutional ownership, and which retail investors should be aware of.
The 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 most retail investors could only dream of. They use these resources to perform in-depth analysis of opportunities.
Does this guarantee that they'll make money in the stock? Certainly not, but it does greatly enhance the probability that they will book a profit. It also puts them into a potentially more advantageous position than that of most individual investors. (To learn more, read "Institutional Investors and Fundamentals: What's The Link?")
Institutions Market the Stock
After some institutions (e.g. 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 to boost share price value.
In fact, that's why you see 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 an institutional investor 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's 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. When funds do accumulate large positions, they do their utmost to ensure those investments don't go awry. To that end, they'll often maintain a dialogue with the company's board of directors and seek 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," many mutual funds have also ramped up the pressure on boards of directors. 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 the hiring of 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.
The 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 fraught, as a portfolio manager having a bad quarter might feel pressured to 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 notorious for placing quarterly demands on their managers and traders. Although this is due less to benchmarking and more to the fact that many hedge fund managers get to keep 20% of the profits they generate, 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 institution decides to sell, the stock will often sell off, which impacts many individual shareholders.
Case in point: When well-known activist shareholder Carl Icahn sold off a position in Mylan Labs in 2004, its shares shed nearly 5% of value on the day of the sale as the market worked to absorb the shares.
Of course, it's hardly possible to assign the total volume of a stock's decline to sales by institutional investors. The timing of sales and concurrent declines in corresponding share prices should leave investors with the understanding that large institutional selling does not help a stock go up. Due to the access and expertise enjoyed by these institutions – remember, they all have analysts working for them – the sales are often a harbinger of things to come.
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, allowing them 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 drawn-out processes that can be bad both for the underlying stock and for the individual shareholder invested in it.
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 some 12% of its value during the three months of back and forth between the parties. Again, while the full blame of the decline in the 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 typically 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 ultimately doing something good, the road ahead can be difficult and the share price can, and often does, wane until the outcome becomes more certain.
The Bottom Line
Individual investors should not only know which firms have an ownership position in a given stock; they should also be able to gauge the potential for other firms to acquire shares, while understanding the reasons for which 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 biggest players in a given stock are making.