Retail v Institutions: unpicking the assumptions

Many retail investors seem to be labouring under the misapprehension that they control the markets. This is a dangerous illusion.

I have been working as a freelance analyst for many years now, for dozens of clients including multi-billion-pound titans like IG Index all the way down to private start-ups whose founders subsist on a diet of mealie meal and dreams. 

And in that time, I have only ever once seen retail investors beat institutions at their own game.

I’m talking, of course, about the extremely entertaining GameStop short squeeze of January 2021, where a few million Wall Street Bets-infused Redditors took on institutions over-shorting the bricks and mortar business, and for one shining moment, beat them at their own game.

While there was the occasional smattering of overnight millionaire stories, we all know what happened next. The ‘buy’ button was turned off, the share price crashed, and acrimonious finger pointing has been ongoing ever since (including the brief resurgence earlier this year).

The purpose of this article isn’t to pass judgment on FINRA or the SEC. It’s to hammer home a point that it appears many retail investors have forgotten: individually, you have very limited power. In fact, you have no power.

Unless your name is Musk, Buffett — or briefly Keith Gill — you’re riding the wave. Not causing it.

Institutional vs retail investors

This will be bread and butter for many of you, but there are many obvious differences between an institutional investor and a retail investor.

Institutions are titanically powerful market actors: think brokers, pension funds, mutual funds, money managers, banks, insurance companies, investment banks, commercial trusts, endowment funds, hedge funds, and private equity. These actors typically account for more than 50% of market volume across western markets, including the US, EU, UK, and Australia.

Retail clients — aka you and me — are individuals who are investing for ourselves. This typically takes two forms; either passively investing into index funds to benefit from the rising boat of the global markets over time, or activity trading individual assets because we think we can beat the market.

Power imbalance

There are many factors contributing to the power imbalance between retail and institutions. The most important — in my view — are:

• Financial firepower — institutional investors have much, much larger amounts of capital to invest than retail investors. They can pool resources from multiple investors and make massive investments, such that one institution can directly impact on an asset’s price trajectory. Further, their size means they can negotiate far better fees on investments, and they can invest in specialised assets with high minimum buy-in costs.

• Influence — institutional investors can move the market, affecting multiple prices and triggering reactions from other institutions and retail investors. You may not like it, but when Goldman says jump, we mere mortals may only ask ‘How High?’

• Research — institutions have entire teams of analysts working non-stop to analyse virtually every asset under the sun to generate a profit. Consider this: a Bloomberg terminal costs circa $24k per terminal, and you are unlikely to have access to one. This is a bare requirement for most institutions — who are often three steps ahead of retail at all times.

• Time horizon — this is related to financial firepower but is important to note. Institutions can hold onto paper losses essentially forever, can always buy the dip, and can weather the storm through recessionary periods. Retail client pockets are millimetres-deep by comparison.

• Risk-reward perspective — institutions have much more advanced risk-based options compared to the classic stop losses and take profits of the retail world. They can fully diversify, hedge positions, and again can absorb losses on a huge scale.

• Regulatory protections — cue the laughter from sceptics, but the one area where retail clients have an advantage is regulatory protection. Regulators are aware that there is a huge power imbalance, so the FCA in particular is keen to ensure that you are relatively well looked after. Of course, this doesn’t prevent you making poor investing decisions.

The AIM difference

One of the key reasons why small caps are so popular with retail investors is that many of the advantages enjoyed by institutions are watered down (to a degree). Yes, you have to contend with leaked information, weak NOMADs, and placing dumps - but at the end of the day, there are hundreds of junior resource companies on AIM alone...and thousands internationally.

And you have a much more level playing field. If you have time, you can conduct your own research and gain an information advantage over the wider market - in companies where often you can have an information advantage on their own broker if you invest enough time. 

Further, retail investors as a group have relatively more power overall in the small cap space. If you look at S&P 500, FTSE 100, or ASX 200 companies — almost all of them have share ownership dominated by a handful of powerful market players, all of whom trade the stock up and down.

This is not the same for most AIM shares. Typically a stock's register may include a handful of individuals with TR1 status (and a broker or institution as a cornerstone), but it's often the case that most shares are in retail hands, many of whom take great pains to be constantly on top of the investment case.

Where it gets really interesting is the liquidity; in illiquid shares, a single trade from one retail investor can be enough to significantly move the market capitalisation of a microcap. But you're not really moving the true value of the company because if you try to buy something unpopular and therefore illiquid, in a larger quantity, then a wall of sellers will push it back down to take advantage of the exit liquidity you are providing. And if you try to sell shares in something illiquid, you will be hit by a giant spread as the buyers are just not there.

Of course, when retail acts as a group, it has influence - but in reality, everyone is working to their own agenda. When Goldman Sachs says lithium might fall further, then every lithium stock in the world dips. When retail decides a stock is good, they can together drive a spike upwards - but pricing control is still out of their hands, and the consensus can break down with a single sell.

Even on AIM, unless you're a HNW, you are not in control. Markets makers and brokers are in charge.

Institutions control the tides. And retail investors don’t cause waves.

We surf them — and hope to catch a profit.

- Charles Archer, 26/7/2024