Advisors facing a choice between an institutional fund and a retail fund should give the former a long, hard look before going anywhere else. That's because institutional funds generally outperform their retail cousins.
Grant Rawdin, CFP and president of Wescott Financial Advisory Group in Philadelphia, says he avoids retail stock funds, which he considers to be more fickle than institutional ones. Rawdin, who manages $550 million, prefers to invest his clients' assets in institutional funds, which are available to qualified plans and financial advisors. Simply put, the cash flow in retail funds is too mercurial, he says. In down markets, when managers should be buying, they sell their most liquid stocks to meet redemptions. In bull markets, the retail funds must invest large cash inflows when stock prices are too high or put the money into cash.
"The institutional funds don't experience huge redemptions," Rawdin says. "The cash flow is more stable. Financial advisors have investors stay put as part of a diversified portfolio."
Over the past several years, Rawdin has been investing in the Janus Advisor Growth Fund instead of the Janus Fund. Blaine Rollins manages both large-cap growth funds. He uses the same stock-selection style in both funds. But he manages the Advisor fund differently because it has just $300 million in assets. It has more flexibility to trade stocks than the Janus fund, which closed its doors last September with $24 billion in assets.
As a result, Janus Advisor Growth Fund posts a higher total return and higher risk-adjusted rate of return than the Janus Fund. Over the past three years ending November 30, the Janus Advisor Growth Fund gained 1.91%, while the Janus Fund is up just 0.71%. On the volatility side, the Janus Advisor Growth Fund sports a standard deviation of 25.29%. By contrast, the Janus Fund has a standard deviation of 28.34%.
Morningstar data show that Rawdin and other financial advisors are on the right track. As a group, diversified U.S. stock funds that limit access only to financial advisors and qualified pension plans outperform retail funds. Institutional funds have generated annualized rates of -8.52%, 5.02%, 8.85% and 13.09% over the past one-, three-, five- and 10-year periods, respectively, ending November 30. This compares with retail funds' annualized rates of return of -9.59%, 4.30%, 8% and 12.09% over the same periods. Over the past three years, the average institutional fund boasts an alpha of 5.8, a Sharpe Ratio ( a measure of risk to reward where the higher the ratio, the better the fund) of -.02 and a standard deviation of 24.25%. By contrast, retail funds have an alpha rating of 5.39%, a Sharpe Ratio of -.08 and a standard deviation 25.14%.
But averages aside, the top 20 performing retail diversified U.S. stock funds over the past five years ending November 30 beat the best-performing fund with institutional and qualified access. Russ Kinnel, Morningstar director of fund analysis, explains the top-performing retail funds did better than the top-performing institutional funds largely because the retail fund managers were more aggressive stock pickers who got rewarded for their risks. But historically, he says, the majority of institutional funds have outperformed retail funds due to several factors.
A major reason is the expense ratios on institutionally managed funds are 40 to 60 basis points lower than their retail counterparts. There is less style drift and tighter limits on what they will buy and when they will sell. On the value side, Kinnel says, an institutional fund manager is less likely to move into growth stocks to pick up some return.
"Institutional funds have tighter investment controls and lower expenses," Kinnel says. "They stay fully invested, and there is less style drift. This makes them more attractive investments for financial advisors and plan sponsors who allocate assets."
Kinnel says cash flows typically are not a factor contributing to the performance differences among large-cap retail and institutional funds. But cash-flow difficulties frequently show up in the mid- and small-cap growth retail funds. Managers of these funds often see hot money moving in and out of their funds. The effect increases expenses and reduces performance.
But even large-cap fund managers say cash-flow volatility makes a difference. John Schneider, manager of the PIMCO Value Fund and the PIMCO Value Institutional Fund, says he would not be able to use his value method of picking stocks in a retail fund unless the cash flows were stable. The fund commingles retail assets with institutional assets.
"I don't have hot money in my funds, and the cash flows have been very steady," Schneider says. "But it is very difficult with no-load (retail) funds. Hot money can flow in one day, and you have to invest. The next day, it's out. It creates high transaction costs, and it is difficult to invest."
Schneider says the fund's institutional share dollars come from 401(k) pension plans, as well as large $1 million purchases from financial planners.
Schneider, whose fund is one of the top 20 performing institutional stock funds over the past five years, buys large-cap undervalued stocks based on intrinsic values. He stays fully invested and sells stocks when they hit their target prices. For example, this year he took profits in utility and tobacco stocks when they hit their price highs. He bought property and casualty insurers like ACE Limited after the September 11 terrorist attacks on the World Trade Center.
Although he manages all share classes of the value fund the same way, he says the institutional share class still outperforms the retail shares.
"The difference in the performance of the institutional fund with the broker-sold funds is the expenses," Schneider says. "The PIMCO Value A Fund expense ratio is 110 basis points, while the institutional fund's expenses are just 40 basis points."
Wallace Weitz, manager of the Weitz Partners Value Fund, adds that it is not always expenses that give funds with large amounts of institutional and financial advisor money the performance edge. This fund-one of the highest-rated Morningstar diversified stock funds with institutional and qualified access over the past five years-has one share class with an expense ratio 1.13%. Weitz says about half the fund's $3 billion in assets comes from pension funds or financial advisors associated with discount brokerage wrap account programs offered by Charles Schwab, Fidelity Investments and others.
The Weitz partners fund typically buys and holds media, entertainment, financial, cable and telecommunications stocks selling below intrinsic value. For example, Weitz recently purchased more shares of Hilton Hotels and Host Marriott and added Disney to his list of holdings during the bear market this year. But if he can't find values, he stays in cash.
By contrast, the Weitz Value Fund has more retail assets and owns more high-dividend-yielding stocks and REITs. The fund also takes profits more frequently than the partners fund. As a result, the value fund traditionally has underpeformed the partners value fund.
"We managed the partners value fund so that it is tax efficient," Weitz says. "We have bought and held stocks during the bull market longer than our other funds. The expenses on the fund are the same for both retail investors and institutional investors.
Bob Perkins, manager of the Berger Small Cap Fund, adds that many small-cap value and growth retail funds keep their coffers open when they should be closed. As a result, these funds are tough to manage. Perkins recently closed his fund to new investors when assets hit $3 billion. Two-thirds of all share-class assets of the fund come from institutional, professionally advised 401(k) assets.
"Some haven't closed their doors," says Perkins, whose fund also is one of the top-performing institutional funds over the past five years. "It hurts when things get shaky. What happens is that you end up with a lot more holdings. There are only so many stocks you can hold without owning 10% or more of a company. Then it becomes difficult to buy or sell the stock without moving the market."
Perkins recently put 12% of the fund's assets in cash. But he says it would be difficult to keep his powder dry if the fund remained open. He invests in companies at a discount to intrinsic value or to future earnings. He wants to have cash ready to snap up companies like WebMonitor. He recently bought the stock at $6, and it trades at just two times cash flow. The firm shows companies how to use the Internet to track the cost of their goods. Perkins expects the company to grow earnings at more than 25% annually.