At T. Rowe Price's annual investment briefing earlier this month,
Growth Stock fund manager Robert W. Smith worried aloud about investor short-sightedness, saying, "Individuals must stop renting stocks and start owning stocks again."
Smith said this trader mentality heightened market instability, and his point was well-taken. Then again, so was a question put to Smith by a reporter: "When do you think fund managers will stop renting stocks and start owning them?"
Smith, the subject of a recent
10 Questions, might be the wrong manager to ask -- his fund has topped the market and most of his peers during the past 10 years while keeping expenses, risk and turnover fairly low. But the discussion illustrates a key point: Money managers, far more than often-blamed individual investors and daytraders, deserve the lion's share of the blame for the market volatility of the past several years, because of their "herding" mentality and performance-chasing. And if the past few months are any indication, plenty of money managers are still acting like traders.
A study in the October
Journal of Finance
titled "Who Blinks in Volatile Markets: Individuals or Institutions?" concluded that institutions -- mutual funds, in particular -- bear more responsibility for short-term volatility than individuals. The researchers compared stocks that were essentially identical except for institutional ownership levels. On "event days" -- days when the market rose or fell by 2% or more -- stocks with high institutional ownership levels were far more volatile than stocks held largely by individuals. They attribute this to "herding" behavior by fund skippers.
"Institutional managers should be a bit brighter and less subject to biases than individuals," said Patrick J. Dennis, a University of Virginia associate professor and co-author of the study with Deon Strickland of the
Securities and Exchange Commission
. The study examined stock market volatility over eight years through the end of 1996. Dennis said fund managers are prone to cause more volatility because of a combination of behavioral finance, "asymmetric information" -- in other words, "thinking that the other guy who is buying may have heard something through the grapevine that I haven't" -- and simply the dictates of their job market.
"A fund manager is competing with other fund managers, and the close scrutiny they face discourages going out on a limb," Dennis said. "If as a fund manager I do what everyone else does, even if I lose money at the end of the quarter, I can say, 'I did what everyone did. You can't fire me.'"
Some fund managers concede this point, saying that not being invested in a "high beta" or higher-risk sectors means lagging behind when they have an extraordinary burst, such as technology and telecom have had since Oct. 9. From a job-security standpoint, that risk outweighs the lesser risk of being invested in those stocks when they crater.
This results in herding into high-beta, erstwhile growth stocks such as
Dennis considers institutional ownership levels of around 45% or above to be high. Institutional ownership in these four stocks range from 52.4% in Microsoft to 70.4% in Flextronics, according to ownership tracker Lionshares.com; institutional ownership as a percentage of public float -- excluding shares held by insiders -- is even higher. These volatile stocks carry greater risks than most. A stock with a beta measure greater than 1 means it is more volatile than the market. The beta range for these four stocks is 1.73 for Microsoft to 3.31 for Flextronics.
Many fund managers
defend their ownership of these battered blue-chip tech stocks, saying the recent downturn has strengthened the leaders. But disproportionately large institutional ownership extends beyond the leaders. Volatile stocks such as wireless-semiconductor company
, which sports a price-to-cash-flow multiple of 131 and a beta of 2.7, and software developer
have institutional ownership greater than 55%. Both stocks have more than tripled from their summer lows, partly because of improved outlooks; Dennis says heavy institutional ownership -- on the long and short side -- can help explain why these stocks have been so volatile. Institutional ownership still runs fairly high even at troubled companies such as
( NT); money managers own 44% of the networker.
"There is a huge contingent of people in the OPM
other people's money crowd who only care about beating the bogey
their benchmark index and getting the horses that are moving the fastest," says hedge fund manager and
contributor Bill Fleckenstein.
Fund investors should pay close attention to their funds' beta levels, which can be found on Morningstar's Web site. While growth funds understandably have a higher beta than value funds, levels far above 1 indicate bumpy rides ahead. (T. Rowe's Smith, for instance, sports a 1.08, an acceptable and relatively low risk level for a growth offering.)
Richard Sias, a Washington State professor who has written extensively on "institutional herding," says institutional ownership levels have a far greater impact on a stock's movement than the company's actual earnings performance.
"If institutions are piling into a stock, as an investor I'd rather be with them than against them," Sias said. He says money managers move in packs because "they are looking at the same signals and, a lot of times, looking at each other's trades. It takes a while for everyone to get in."
While this leads to short-term surges in certain hot stocks and sectors, Sias said herd movements have negative longer-term implications as stocks get overvalued and the herd begins to sell
. He also noted that while institutional managers tend to pick stocks better than individual investors do, the costs of active trading are greater than the marginal benefits.
"The market isn't Lake Wobegon; we can't all be above average," Sias said.
Some fund managers acknowledge that the performance-chasing and overly active management may not be the best thing for their portfolios. At the annual Legg Mason Asset Management conference earlier this month, Value Trust manager Bill Miller, the only manager who has been "above average" against the
for 11 years and counting, noted anecdotally that his fund would have performed better if it had remained static -- making no changes to its 2002 portfolio as it stood on Jan. 1. When his researchers went back to the beginning of 2001, they learned that a static fund would have outperformed the real-world, actively managed fund by a few percentage points. While Miller believes that high-beta (but not necessarily tech) stocks will pace the market's recovery, he hinted that a less-frequent turnover at his fund may be in store.
It is doubtful that the herd of fund managers will follow suit, says the University of Virginia's Dennis, who says overall volatility may keep rising as mutual funds continue to grow as a piece of the equity ownership pie. However, T. Rowe Price's Smith signaled that his firm's offerings may head in that direction as well. In responding to the reporter's question, the skipper acknowledged that many fund managers have gotten careless during the past few years -- chasing performance, taking their eyes off fundamentals, getting trade-happy. "We've realized we're good investors, but we're not always the best traders."