Weaknesses of Institutional Investors - Cryptocurrency Exchange Platforms

One of the weaknesses of institutional investors: inability to hold cash

I am planning to start a series discussing a range of weaknesses of institutional investors.

The first weakness is that institutional investors generally find it very difficult to hold cash, which is a dead end for them. Typical funds have many regulations, such as maintaining a position of at least 75%, regardless of whether it’s a bear or bull market. This is a rigid rule.

Why are there such regulations? Because fund managers are managing other people’s money. For these investors, they are more afraid of missing out, because if they miss the opportunity, the public fund buyers will be dissatisfied. In a bear market, if the entire crypto and stock markets fall, the funds also decline. These investors may be unhappy, but they don’t care too much because everyone is falling. Many people also choose not to watch the crypto and stock markets during a bear market.

In a bull market, some crypto and stock prices have risen too high, overvalued, and should be sold, but they don’t sell because prices might go even higher. Once they are fully invested, if the bull market continues, investors may become dissatisfied due to reduced returns caused by holding positions, and eventually switch to other funds. This is what fund managers fear most. For this reason, funds are reluctant to hold cash.

At the same time, this is also in their interest. Because they manage other people’s money and survive on management fees, not on how much profit the fund actually makes. Therefore, they care about the size of the fund under management and worry about losing clients. This is the fundamental reason why funds have rigid position regulations.

If they can’t hold cash, they have no liquidity. When a market crash occurs, and we see good crypto and stock opportunities, but they have no cash—because their stomachs are already full—they lack the capacity to seize these opportunities and cannot generate excess returns.

The risk of always being fully invested is also very high. Especially when crypto and stock prices are overvalued, the position itself becomes a risk, opposite to the safety margin, turning into a risk margin. If a downturn occurs, being fully invested means being caught in a decline. If the company’s value is overestimated, it could be a permanent loss unless a more aggressive bull market occurs after the bear market or there are some unexpected improvements in business operations. But these are low-probability events, at least with time costs.

On one hand, being fully invested at the end of a bull market carries great risk. On the other hand, during a bear market, lacking cash means missing out on excess gains. Since risk and return are the two main factors in investing, fund investors’ returns often lag behind the average crypto and stock index.

This is why successful value investors like Warren Buffett and Seth Klarman always hold large amounts of cash, especially during bull markets, when they have even more cash. This may cause their current returns to be temporarily lower, but it gives them the opportunity to buy high-quality crypto and stock assets at low prices during market crashes, such as during the current pandemic. Buying more at low cost and with lower risk can lead to huge future gains.

In reality, during market crashes, private equity funds often operate in the opposite way of value investing—they not only are fully invested but also leverage their positions. When the market is collapsing, they must repay their debts. If their capital chain breaks, they face margin calls and forced liquidations. The bottom of a bear market is often marked by these forced liquidations. These assets become the fodder for value investors, who are their buyers. When the bull market returns, value investors reap significant gains.

Therefore, the inability of most institutional investors to hold cash is their Achilles’ heel. Don’t think that institutional investors are very mysterious; they are not as high-level as you might imagine.

Weakness 2 of institutional investors: short-term performance evaluation

Today, we discuss another weakness: short-term behavior.

Many believe that institutional investors are value investors and should focus on long-term holding. But that’s not entirely true. If you understand how these funds operate and what their incentive mechanisms are, you’ll see why they tend to behave short-term.

Every year, fund managers are ranked by performance. Sometimes once a year, sometimes quarterly or monthly. High performers attract more fund buyers and investors, increasing the fund’s size. The larger the fund, the more management fees it can collect. Consequently, fund managers earn higher bonuses, which motivates their short-term focus.

Under this incentive system, they seek to generate returns within a short period—one month, one quarter, or at most one year. What happens after that doesn’t matter much to them, nor does it affect their personal bonuses.

This incentive structure leads to short-term behavior among fund managers. Although they are smart and understand value investing, even if they see some high-quality companies or assets with low prices and safety margins, they dare not buy. They don’t know when the value will revert if they buy in the opposite direction. They face significant time and risk costs—if they don’t achieve good returns in the short term, their bonuses may disappear.

This poses a great professional risk for fund managers. Even if they buy a good, undervalued company, if it only rises after two years, they are finished. Their performance is evaluated monthly, quarterly, or at most annually.

We have said that value investing is contrarian. The buy-in points during a downturn are often not the lowest. When the market recovers, even fund managers who correctly predicted the rise may be caught unprepared—“buying the dawn.” It’s not because they are stupid or have flawed cognition, but mainly because of the fund’s evaluation system.

Their personal bonus risk and career risk are too great for them to follow a true value investing approach—buying with safety margins and patiently waiting. They know contrarian investing benefits retail investors, but they won’t do it. Normally, when safety margins exist, they should buy more when prices are lower, at cheaper prices, and increase their holdings, leading to higher future returns. But fund managers don’t think this way—they need commissions and fear being fired.

Thus, a situation arises where high-quality crypto and stock assets with safety margins are falling, but fund managers don’t buy; instead, they sell because they fear prices will fall further. They worry that further declines will hurt next month’s or next quarter’s performance, so they act contrarily. Even if they understand value investing, their behavior is driven by personal interests.

Conversely, overvalued assets that are rising are also understood as overvalued, but they won’t sell. Selling might mean missing out if prices continue to rise. Missing out on gains would hurt their ranking and could lead to losing investors. So they prefer not to sell, prioritizing personal interests over clients’ interests.

This is why crypto and stock market bubbles are driven by these managers’ psychology—they hope the overvaluation will continue to rise until their bonuses are paid. Overvalued assets will eventually fall, but the fund managers’ bonuses are secured quarterly and annually.

This might be an advantage for individual investors: these fund managers are smart but short-term oriented. They compare themselves with each other, often chasing gains and selling in panic, refusing to sell high and buy low. They are essentially big retail investors in suits, as Charlie Munger and Warren Buffett have said.

Fund managers are human, with all human weaknesses—like herd mentality. They tend to follow each other: what one buys, others follow, forming groups. When markets fall, they rush to sell, causing crashes. Fear and greed make them unable to withstand price fluctuations.

Some fund managers, especially private equity funds, are even more extreme—they leverage heavily. They are more prone to panic and have strict liquidation rules. Because of leverage, they are more sensitive to short-term declines—if prices drop 10%, they might see a 20% decline. These short-term behaviors often lead to mediocre returns, which may look good in the short term but rarely outperform the index over the long term.

In summary: institutional investors and fund managers are short-term actors. Their incentive mechanisms make them focus on short-term gains and personal interests. In short, they are just big retail investors in suits.

Weakness 3 of institutional investors: overly diversified holdings

Today, we continue with the third weakness: overly diversified holdings. Most funds hold many companies. The reason is simple: these funds have large capital bases and rigid regulations, such as “no single company exceeding 10%,” and internal risk management also requires diversification. Their goal is to keep return volatility manageable. Some funds hold hundreds or even thousands of companies, both in China and the US.

The problem is, with only one or two fund managers and a few analysts, managing hundreds of companies makes it impossible to focus. Like a business owner with hundreds of subsidiaries—how can they manage all of them? They can’t understand each one thoroughly. No matter how energetic they are, they only have 24 hours a day. Even with great ability, their attention gets diluted. Dilution itself doesn’t reduce risk—poor companies remain poor. Increasing the number of holdings doesn’t reduce risk; it only dilutes returns.

Investing is a game of cognition. The deeper your understanding of a company and its industry, the greater your chances of winning in this game. It’s a matter of capability. Even if you’re smart, if your attention is scattered, you can’t develop a deep capability circle. Like a giant fighting a hundred people—eventually, they lose because their energy is divided.

Fund managers holding numerous companies greatly diminish their capability circle—this is the enemy of investment. Most funds suffer from this problem; their capability circles are weak. No matter how smart the fund managers are, their returns are unaffected because their capacity is diluted.

As individual investors, we have an advantage. We may not be very smart or have access to abundant information, but we can focus. We can deeply research one company, devote all our energy to it, and think independently. Even with less capital, we can concentrate our efforts, expand our capability circle, and eventually break through at a point.

This is very similar to warfare: when facing a stronger opponent, the key strategy for the weaker side is to concentrate forces. We focus our capability circle on in-depth research, using it to gain an advantage. The opponent is big but not strong; we are small but strong.

Focusing on one point creates significant pressure—like a needle piercing a tough obstacle. This is the advantage of individual investors.