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  Staying Focused on Long-Term Investment Goals: The Institutional Approach

Wilshire Funds Management annually examines the investment returns and relative performance of retail investors as compared to their institutional investor counterparts. Although capital markets present similar levels of uncertainty for all participants, institutions have consistently outperformed retail investors over various time periods, as illustrated in Exhibit 1, below. This paper will review trends within retail investing in an effort to better understand certain dynamics that drive investor decision making. We will also examine the institutional approach to investment management, with the goal of identifying investment characteristics retail investors might consider adopting.

We use data from DALBAR’s 23rd Annual Quantitative Analysis of Investor Behavior Report (the “DALBAR Report”) and the Wilshire Trust Universe Comparison Services® (Wilshire TUCS®”) in our analysis. The DALBAR Report utilizes monthly mutual fund sales, redemptions and exchanges as the measure of “average investor” behavior. Wilshire TUCS® is a cooperative effort between Wilshire Associates and several global custodian banks and trust companies to aggregate the asset allocation and holdings data of more than three trillion dollars of U.S institutional assets. For the purposes of this paper, data from Wilshire TUCS® is used as a proxy for institutional investor performance. Wilshire TUCS® provides plan data contributed gross of fees by the participating custodian bank or consultant and its calculated using accounting inputs and computational method standards.

Exhibit 1: 10-Year and 20-Year Annualized Returns for Average and Institutional Fund Investors Ending 12/31/2016

Chart illustrating how institutions have consistently outperformed retail investors over various time periods

Source: DALBAR’s 23rd Annual Quantitative Analysis of Investor Behavior Report the (“DALBAR Report”) and the Wilshire Trust Universe Comparison Services® (“Wilshire TUCS®”). The DALBAR Report utilizes monthly mutual fund sales, redemptions and exchanges as the measure of “average investor” behavior.

Wilshire TUCS® is a cooperative effort between Wilshire Associates and several global custodian banks and trust companies to aggregate the asset allocation and holdings data of more than three trillion dollars of U.S institutional assets. Data on the average institutional investor is from Wilshire TUCS®, which represents the median total returns of master trusts- all plans, and is as of 12/31/16. Data on average the equity fund investor, average bond fund investor, average asset allocation fund investor and inflation are from the DALBAR Report. The chart shown intends to demonstrate what Wilshire believes to be the effect of behavioral biases such as market timing, exhibited by retail investors. Other factors that may materially affect the difference in returns between retail and institutional investors include but are not limited to: size of asset pool, investment horizon, liquidity requirements, restraints and access to types, varieties and brands of investments and lower-fee investment options. The reader should view these returns in consideration of other relevant factors and should not rely solely on performance data shown.

While there are key differences between institutional investors and their retail counterparts, such as different investment horizons, investment types, liquidity requirements, and the larger asset pools that generally give institutional investors access to lower investment fees, a wealth of data, including some depicted here, suggests that individual investors could nonetheless benefit from taking cues from their institutional counterparts to improve the overall performance of their portfolios.

Retail Asset Flows

Evaluating the flow of funds to and from specific asset classes has proven useful when striving to understand the tendencies of retail investors. Exhibit 2 charts the net flow of capital in and out of U.S. mutual funds against the growth of a hypothetical $10,000 investment in the Wilshire 5000 Total Market IndexSM, an index which measures the performance of all U.S. stocks with readily available price data, from January 2008 to December 2016. Mutual fund flows are useful in tracking the asset allocation decisions of individual investors, as institutions often invest through separate accounts.

Since the bottom of the financial crash in March 2009, the stock market has entered one of the longest bull runs in history, as depicted in Exhibit 2, with the value of a $10,000 investment on February 2009 more than tripling over the ensuing seven-year period. In the same time period, equity flows have remained consistently negative, while bond flows have remained mostly positive as retail investors chose safety over potentially higher returns. Additionally, the variability of capital movement in and out of mutual funds, known as the volatility of fund flows and attributable in part to market timing efforts, has also continued to increase post-2008. Even minor market dips are often followed by significant outflows from both equity and bond mutual funds. For example, from July through September 2015, as oil prices plummeted and fears of China’s stagnating economy grew, investors panicked over market uncertainty and pulled out of the market, causing them to miss out on a 13% gain if they had held steady until December 2016.

Exhibit 2: Inflows and Outflows of Equity and Bond Mutual Funds: January 2008–December 2016

Chart illustrating the net flow of capital in and out of U.S. mutual funds against the growth of a hypothetical $10,000 investment in the Wilshire 5000 Index.

Sources: Wilshire CompassSM, Investment Company Institute.

DALBAR’s Guess Right Ratio

Exhibit 3 below charts DALBAR’s Guess Right Ratio, which depicts the frequency with which investors “guess right” in their attempts to time the market. In general, when the Guess Right Ratio exceeds 50 percent, investors have made money from their allocation decisions. In 2016 the average investor was only able to “guess right” 42% of the time, or five out of twelve months, demonstrating that emotional and reactionary investment decisions can be damaging to long-term performance.

Exhibit 3: DALBAR’s Guess Right Ratio

Chart depicting the frequency with which investors guess right in their attempts to time the market.

Source: DALBAR Report, Wilshire Compass.

Comparing the Performance of Individual and Institutional Investors

A wealth of data suggests that individual investors should take their cues from their institutional counterparts and remain committed to their long-term strategic asset allocation. Exhibit 4 below depicts the performance penalty paid by individual investors making emotional investment decisions.

Exhibit 4: Average Annual Returns from 1996–2016

Chart depicting the frequency with which investors guess right in their attempts to time the market.

Source: DALBAR Report.

According to the DALBAR Report, for the 20-year period ending December 31, 2016, the average stock fund returned 7.7% annually, while the average stock fund investor returned only 4.8%. Attempting to time the market penalized the average stock fund investor to the tune of 2.9% per year, nearly half of the return they would have achieved had they remained invested. Although this penalty gap has modestly decreased from the year prior, down from 3.5% in the 20-year period ending December 31, 2015, the disparity remains wide. Unlike many individual investors, institutional investors adhere to a structured investment policy to provide a framework for their decision-making process and to curtail the potential for emotional investing. For example, in 2009 many individual investors succumbed to fear and exited the equity market while institutional investors remained committed to their asset allocation policy. By not deviating from policy, institutional investors were able to recover more quickly than individual investors who pulled out of the market altogether.

Remaining committed to an investment policy is not synonymous with setting and forgetting your portfolio. Exhibit 5 illustrates the asset allocation shifts that master trusts (all plans) made from 1996 to 2016. Regular reallocation and rebalancing activities based on long-term objectives and capital market assumptions is consistent with the best practices of successful institutional investors. It is in large part by exiting the market and attempting to guess the most opportune time to re-enter that individual investors jeopardize the ability to achieve their investment goals.

Exhibit 5: Shifting Institutional Allocations, Master Trusts (all plans) Over $1 Billion, 1996–2016

Chart illustrating the asset allocation shifts that foundations and endowments over $1 billion made from 1996 to 2016.

Source: Wilshire TUCSSM

Conclusion

There are a number of advantages that contribute to institutional investors’ consistently better performance relative to their retail peers. In addition to the meaningful benefits of lower fees and access to certain asset classes like private equity and hedge funds that are cost-prohibitive for many retail investors, institutional investors adopt a longer-term mindset, digesting poor earnings, market corrections and economic shocks as a normal part of market activity. Conversely, many individual investors monitor their portfolios on a daily basis, often making impulsive investment decisions in the face of short-term market dislocations. Further, the practicality of managing large amounts of money involves adherence to firm policy targets, naturally enforcing more disciplined investing. Institutions are innately long-term oriented, allocating capital based primarily on set targets rather than fleeting short-term trends.

These key characteristics and constraints have proven to benefit institutional performance over time, and the continued outperformance of institutional investors supports our thesis that a thoughtfully diversified asset allocation policy has the highest likelihood of maximizing risk-adjusted returns over a full market cycle, defined as a time period that contains a wide range of market conditions. No one has certainty as to what the market will deliver, which makes timing the market virtually impossible. Staying focused on long-term goals, diligently monitoring risks and exposures, and broadly investing with an institutional mindset is a timetested approach that has been shown to produce better long-term outcomes.

Important Information
Investments in equities are subject to market risk. Security prices can fluctuate significantly in the short term or over extended periods of time. These price fluctuations may result from factors affecting individual companies, industries, or the securities market as a whole.

Investments in international equities involve additional risks including currency rate fluctuations, political and economic instability, differences in financial reporting standards, and less stringent regulation of securities markets.

Investments in bonds are subject to interest rate, inflation, credit, currency, and sovereign risks.

Investments in real estate securities have risks similar to those associated with direct investments in real estate, including falling property values due to increasing vacancies or declining rents resulting from economic, legal, political or technological developments, lack of liquidity, limited diversification and sensitivity to certain economic factors such as interest rate changes and market recessions.

An alternative investments strategy is subject to a number of risks and may not be suitable for all investors. Investing in alternative investments is only intended for experienced and sophisticated investors who are willing to bear the high economic risk associated with such an investment.

Wilshire Funds Management is a business unit of Wilshire Associates Incorporated. Wilshire Funds Management uses mathematical and statistical investment processes to allocate assets, select managers, and construct portfolios and funds in ways that seek to outperform their specific benchmarks. Past performance does not guarantee future returns, and processes used may not achieve the desired results.

Wilshire® is a registered service mark of Wilshire Associates Incorporated, Santa Monica, California. All other trade names, trademarks, and/or service marks are the property of their respective holders.

This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice.

Information contained herein that has been obtained from third party sources is believed to be reliable, but has not been verified. Wilshire gives no representations or warranties as to the accuracy of such information, and accepts no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy in such information and for results obtained from its use.

© 2017 Wilshire Associates Incorporated. All rights reserved. Information in this document is subject to change without notice.

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MORE IN THIS CATEGORY: Institutional Expertise, White Papers

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2017 Third Quarter Market Update
  • Presented by: Josh Emanuel, CIO, Wilshire Funds Management
  • Date: Wed., Oct. 18, 2017