Smart Money? Institutional investors have traditionally been referred to as “smart money” because of their reputations, but is this designation warranted? After all, individual investors typically want to know where big firms are investing because they perceive those firms as having the inside scoop — being exceptionally well-trained, experienced and well-informed.
But can investors really outperform the markets by following the so-called “smart money” institutional investors like hedge funds, investment banks, pension funds and mutual funds? The short answer is yes; however, there are some stipulations.
Four signals from institutional investors to follow
This is an important study in light of the fact that institutional ownership has been steadily rising over the last ten years. Although there was a pullback recently, institutions have owned more than 70% of all public U.S. stocks since 2005 with a steady uptrend.
S&P Global Market Intelligence conducted the first study of its kind to determine if it really pays to follow these investors. The firm benchmarked its results with the Russell 3000 Index and constructed models that show how institutional ownership signals enable individual investors to outperform the stock market. In their report titled “An IQ Test for the ‘Smart Money,'” analyst Vivian Ning and team list four institutional ownership stock selection signals: ownership level; ownership breadth, change in ownership level; and ownership dynamics.
Smart Money – Ownership dynamics the strongest signal
Ning and team found that the most reliable trade signal of the four the list is ownership dynamics, which basically looks at changes in the concentration of multiple institutional investors, including share turnover, the duration of their average investment, and other factors. They learned that this signal is the best indicator of both long- and short-term stock performance.
They also found that the size of the institution makes a difference in how it impacts stock price performance. The bigger the investor, the stronger the results generated by them. Further, it appears as if U.S. stocks are the most impacted by institutional investors. The S&P team said that while stock performance was affected by institutional ownership around the globe, the correlation was particularly strong in U.S. stocks.
Smart Money – Where real outperformance was found
Ning and team conclude that the biggest outperformance came from investment strategies that combine data on institutional ownership with fundamental data on the companies. In fact, they said that researchers following such a strategy improved their long-only returns by 23% and their long-short returns by 32% compared to strategies that only used fundamental data for Russell 3000 companies.