You have probably heard of an Index fund, but you might not have heard of an Institutional fund. Index funds seem to be getting more and more popular as a means for investing with minimal fees, but institutional funds have been outperforming index funds, and I will show you how.
These type of mutual funds are not actively traded, and the only purpose of the fund is to keep the stocks in their fund that are listed in specific index. For example, the S&P 500 is an index made up of the 500 largest publicly traded companies in America. Thus a S&P 500 Index fund would hold those 500 stocks, and that is all. When the list of 500 companies changes, they sell the companies that exited the list, and buy the companies that jumped into the list.
Institutional funds are similar to index funds, but go 1 step further. These type of mutual funds dont worry about what is listed in indexes, but have specific criteria for evaluating each stock. They put each of the publicly traded stocks throughout the entire world into different categories based on size, country, and other factors. They then take those categories and weight them based on nobel prize winning studies like the 3 factor model and modern portfolio theory. They then can be specifically weighted in a investors portfolio based on each investors risk preference, which is decided by the investor and the advisor together.
The Proof is in the Pudding
Lets compare index funds to the institutional funds offered through us, aka Matson Money. We will look at real annual returns over the last 15 years from 2000 through 2014 for a few different sectors of the market. Note, all of the numbers shown are after subtracting of all mutual fund management fees.
Large Cap Value Sector:
Retail Index Fund*- 5.56%
Institutional Fund Used by Matson Money- 8.44%
Small Cap Sector:
Retail Index Fund* – 8.32%
Institutional Fund Used by Matson Money- 9.46%
International Small Cap Sector:
Retail Index Fund* – 6.48%
Institutional Fund Used by Matson Money- 8.55% 1.
Doing this type of comparison doesn’t even point out another other obvious advantage to institutional funds. Institutional funds allow for everyday investors to get into sectors that you cannot get into with Index funds, like micro cap (very small companies), Emerging markets Small and Value (Countries that are less established). Returns in those categories have been huge going back 15 years as well.
To get slightly more technical, I have included a few more important weaknesses of index funds as written by Dan Solin in a recent article.
1. Flexibility When to Buy and Sell Stocks
An index fund buys and sells stocks when they enter and leave the index. An institutional fund has the ability to reduce turnover and increase tax efficiency by establishing a range that permits it to hold a stock even if it drops out of the index. 2.
2. Flexibility in Stock Selection
An institutional fund can establish a screen to exclude categories of stocks with historically poor returns, like initial public offering stocks. An index fund manager does not have this flexibility. 2.
3. Use of Block Trading Techniques
There are sophisticated trading techniques a small cap, institutional fund manager can use that are not options for index fund managers. Because the market for these stocks is relatively small, and dumping a large block can affect the stock price, an institutional fund may be able to buy these stocks at a favorable price from a seller who has an urgent need to liquidate holdings. 2.
By Jimmy Hancock
*Retail Index Fund numbers come from Vanguard Index Funds
1. Matson Money. Investor Jeopardy Powerpoint. Mason, OH: Matson Money, 3 Aug. 2015. PPT.
2. Solin, Dan. “Solving the Mystery of Passive Asset Class Investing.” The Huffington Post. TheHuffingtonPost.com, 21 Jan. 2014. Web. 23 Jan. 2014. <http://www.huffingtonpost.com/dan-solin/solving-the-mystery-of-passive-asset_b_4627737.html>.