Institutional mutual funds have an advantage

Many American investors by now are familiar with retail mutual funds. Popular names like Janus, Fidelity, and Vanguard are advertised widely and fill the portfolios of many investors. What many don’t know are their more refined cousins – institutional mutual funds. Where a retail mutual fund will take any investor who knocks on the door, an institutional fund accepts only a smaller group, usually retirement plans and the clients of investment advisors.

Institutional funds do little advertising. That means many investors don’t realize the advantages of investing in them. For one, it appears that institutional stock funds have a performance edge over retail funds. Data from Morningstar Inc., an independent fund advisory firm, shows that the average institutional diversified stock fund has beaten the average retail diversified stock fund over the last 10 years.

There are some good reasons that institutional funds have an advantage over retail funds. First, institutional funds do a good job of holding down their operating expenses, partly because they don’t have the marketing costs of retail funds. Also, institutional funds don’t have to cater to the investment public’s latest whims. They can stick more closely to a long-term investment philosophy, where a retail fund may have to shift gears in order to keep up with its competitors in the race for the best-advertised performance.

Institutional funds also have an advantage in that they can stay more fully invested than retail funds. They do that because their cash flows from investors—in other words, buy and sell orders—are more stable than retail funds. Unguided investors in retail funds tend to pile into the funds when markets are rising and flee quickly when markets fall. Investors in institutional funds receive more guidance that tends to make them buy and hold. This means the funds don’t have to engage in panic selling to meet investor redemptions. They can buy when other investors are selling and sell when others are buying.