Institutional Trading: From Size Challenges to Market Influence

Understanding the ‘Size Problem‘

In our morning meetings, William O’Neil (Bill) would often talk about what he referred to as the “size problem,” with regard to the way extremely large institutions go about buying stocks and accumulating positions.

What exactly defines an “extremely large institution?”

Well, depending on who you ask, the answers you get may vary. These can be Hedge Funds, Mutual Funds, etc. However, at some point along the way, assets under management reach a point where it is no longer feasible to enter or exit a stock all at once, or even all in one day, no matter how liquid it is.

I can tell you from personal experience that trying to liquidate over $1 billion of stock quickly, in an effective, efficient manner, on a day where everyone is running for the exits, can be a very tricky business.

Not to mention, you have to consider that you may be wrong in your assessment and recognize the difficulty you will face in having to reestablish your long positions.

For the street’s largest banks, funds, trusts etc. exiting the market in a major way is not a choice for exactly that reason, which is why most have a standing policy that requires them to stay almost completely invested at all times. For many, a 10% cash position is unthinkable. 5% is typically the maximum amount. This is one clear way retail traders have a significant advantage over large funds and “smart money”.

The Challenges of Large-scale Trading

Bill would use the analogy of comparing a speed boat to an aircraft carrier to depict this situation. It’s very easy to make a quick u-turn if you are in a relatively small, maneuverable boat should the decision need to be made in a hurry. However, the same cannot be said if you are in something the size of an aircraft carrier. They are simply too big, too slow, and take too much time to change directions.

The same goes for institutional money managers running billions and billions of dollars. Imagine if the manager of a $30 billion growth fund made the decision to go to cash right as the market bottomed. They would be hard-pressed to buy all their positions back without significantly impacting performance, and would most likely find themselves out of business in a hurry. This is why these guys stay almost entirely invested at all times.

Additionally, it’s important to remember that it can take weeks and months for the largest institutions to accumulate a full position in a stock, or conversely, to unwind an entire position.

This is because if even just one of these huge funds attempted to buy or sell an entire position, all at once, using a market order as a stock was either breaking out of a base or breaking below key support levels on heavy volume, it would impact the stock’s price far too drastically for this to be a feasible way for large institutions to establish positions.

Even when they do their very best to buy a stock discreetly, within a certain range over time, it’s very hard for them to hide their tracks due to the sheer size of their positions.

Remember, institutional investors account for more than 70% of the market’s total volume. So, what do you think happens when 10, 20 or more of these monster-sized institutions all decide they want to buy the same stock?

The Dominance of Institutional Investors

For starters, volume picks up noticeably on a stock’s chart, which is always our first major clue that institutions are getting involved and then price follows, often exploding higher as the biggest and best institutions go about accumulating their positions. Bill used to compare this to an elephant getting into a tub full of water.

Distinctive Strategies of Large Institutions

Extremely large institutions must begin to buy or accumulate stocks well in advance of their classical breakouts, and sell or distribute stocks into strength on their way up, before they show obvious signs of weakness and begin to break below key levels of support.

Another key difference worth noting is the way large institutions view performance. Their goal every year is to beat the market, and most use the S&P 500 as the benchmark for their performance. So, what often happens is that they will closet index most of their capital, meaning they do their best to shadow or replicate their benchmark index, and then use the remainder of their capital to take more concentrated positions in their very best names, with the hopes of outperforming the market.

This means that during the years when the general market is down, being down less than the market is considered a win for these guys. For example, if the S&P 500 is their benchmark and it ends the year down 17%, then being down 16% or less is considered a “win” for them, because they beat the market or their comparative benchmark.

Obviously, this is a much different game than most of us are playing as individual investors, or even professional money managers with less money to manage.

There are an endless variety of ways to manage money on Wall Street from growth to value and everything in between. Believe it or not, there are a surprising number of professional money managers out there, running billions of dollars in the stock market that are 100% fundamentally based and don’t employ any form of technical analysis whatsoever.

Therefore, I can only give you my perspective, from my own experience as a growth manager, employing a fairly rigid system of fundamental growth criteria, as well as technical analysis to analyze a stock’s supply and demand and to manage risk.

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