Advisors can learn from the strategies of institutional investors

Financial advisors can learn valuable lessons from institutional investors when designing tactical portfolios for retail clients, investment experts said on Monday.

Invesco Trimark’s Rob Kochel, vice-president of national accounts, and Michael Cooke, vice-president of alternative strategies, noted that institutional investors often produce attractive returns while limiting volatility.

“They tend to have a pretty good track record of generating better returns than the average individual investor, and in many cases, doing so with less risk than the average individual investor,” said Cooke, speaking at the Canadian Institute of Financial Planners’ Annual National Conference in Niagara Falls.

He encouraged advisors to look at the best practices of major investment funds and replicate these practices for their clients. One common practice among institutional investors is the use of more comprehensive portfolio diversification than retail investors.

In addition to equities and fixed income, these institutional investors typically hold exposure to such asset classes as private equity, commodities, real estate, and other alternative asset classes.

As many investors began questioning the effectiveness of portfolio diversification in 2008 and early 2009 — a period when nearly all asset classes suffered significant declines — institutional investors continued to rely on their diversification strategies.

In fact, Cooke noted that they enhanced their diversification during this period. In 2009, institutional investors’ alternative investment holdings rose to represent an average of 51% of their portfolios, up from 46% in 2008.

“This evidence would suggest that in fact they continue to increase their allocations to non-traditional asset classes, oftentimes at the expense of the traditional asset classes that anchor most client portfolios,” Cooke said. “They are very dedicated in their allocation to these non-traditional, or alternative asset classes.”

This added diversification smoothes out returns and reduces volatility for clients, Cooke said. In addition, he said these alternative asset classes can be used strategically to enhance returns in certain economic environments.

“Perhaps, a better way to go about building portfolios is to look at those that are designed to defend against any and all of the economic eventualities,” he said.

For example, during periods of non-inflationary economic growth, Cooke recommends holding developed market and emerging market equities, private equity, hedge funds, and long-short equity strategies. During periods of inflationary growth, he recommends shifting your clients’ holdings to include such asset classes as commodities and natural resources, real estate and floating rate securities. And in a recession, he suggests increasing a client’s holdings of long-term government bonds.

While it used to be very challenging for individual investors to get exposure to many of the alternative asset classes, Cooke said recent developments have made these types of investments much more accessible to retail investors.

“Investment technology now exists that allows us to do many of the things that these institutional investors are doing on behalf of their clients,” he said.

Institutional investors also tend to diversify their portfolios more effectively than retail investors in a geographical sense, according to Kochel. He said the vast majority of individuals invest with a strong home bias, which often adds risk to their portfolio due to high geographical concentration.

“You have to be able to neutralize that bias that continues to grow with investors,” said Kochel. He said individuals could learn from institutional investors, who generally spread out their exposure across many geographies.

“The institutional approach allows you to expand your lenses a little wider,” he said.