The Suckers at the Investment Table

If you cannot spot the fish in your first half hour at the table, then you are the fish.

Michael McDermott, from the movie “Rounders,” played by Matt Damon

New research confirms that institutional investors, such as mutual funds, outperform the market before fees, and they do so at the expense of retail investors. That is bad news for retail investors and for investors in active mutual funds, who underperform after fees.

A large body of evidence, including studies such as “Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses,” “Asset Managers: Institutional Performance and Factor Exposures,” “Yes, Virginia, there are Superstar Money Managers” and “Behavioral Biases in the Corporate Bond Market,” has found that institutional investors (such as mutual funds) have sufficient stock-picking skills to generate gross alpha – the stocks and bonds they buy go on to outperform and their sales go on to underperform (before fees). Given that outperformance is a zero-sum game in terms of gross returns, those institutional investors must be exploiting some other group of investors who are generating negative alphas even before considering investment expenses.

These findings are entirely consistent with those from research on the performance of retail investors, including “The Behavior of Individual Investors” and “Industry-Based Style Investing.” The research finds that the stocks and bonds individual investors buy go on to underperform and the ones they sell go on to outperform – demonstrating that retail investors are “dumb money.” The study “Attention Induced Trading and Returns: Evidence from Robinhood Users” found this to be especially true when retail investors “herd.”