At T. Rowe Price's annual investment briefing earlier this month, ( PRGFX) 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.
HerdingA 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.'"
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 SkyWorks ( SWKS), which sports a price-to-cash-flow multiple of 131 and a beta of 2.7, and software developer Citrix Systems ( CTXS) 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 Nortel Networks ( NT); money managers own 44% of the networker.
Beta MaxSome 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 Microsoft ( MSFT), Intel ( INTC), Flextronics International ( FLEX) and Cisco ( CSCO). 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
"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 Real Money.com 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.)