Retail traders can beat institutional traders by being patient and targetting small and unregulated markets. Retail traders can wait for the best opportunities to present themselves, whereas institutional traders may need to make suboptimal investments to track benchmarks or due to investment mandates.
In this post, we’re going to continue discussing the advantages and disadvanages retail traders have when compared to insitutional traders, and how retail traders can beat institutions.
- Hedge Funds vs. Retail Traders
- Where Hedge Funds Have the Advantage
- Where Retail Traders Have the Advantage
- Retail Traders Can Beat Institutional Traders
- The Takeaway
Hedge Funds vs. Retail Traders
Let’s start by talking about hedge funds and retail traders and the resources available to each.
Both institutional and retail traders trade securities intending to make a profit. But that’s about where the similarities end.
Retail traders, also known as individual traders, trade securities with their own money. They can trade most of the more popular securities, including stocks, bonds, options, and futures, but they do not typically have access to IPOs and more complex investment vehicles.
The other primary type of trader is an institutional trader. This type of trader buys and sells securities for accounts they manage for others, including individuals, groups, or institutions. Institutional traders almost always have access to more capital, a more diverse range of assets, and more sophisticated technology.
It’s easy to fall into the trap of assuming that because institutional traders and hedge funds have access to so many more resources than retail traders, there’s no way for the little guy to compete. But this isn’t necessarily true. It’s a classic case of David and Goliath. There are ways for the little guy to beat the giant, and with the increased offerings and sophistication of online brokerages, it’s becoming more and more feasible.
Where Hedge Funds Have the Advantage
Retail traders may have the ability to beat hedge funds, but we’re living in denial if we ignore the ways hedge funds do have an advantage. Therefore, before we get into the advantages retail traders have, and how they can use them to beat hedge funds, we’ll quickly walk through the areas where hedge funds have an advantage. The advantages we’ll discuss follow into the following six categories:
- More Bargaining Power
- More Support Services
- Wider Range of Financial Products
- Top Quality Infrastructure
More Bargaining Power
A significant advantage for hedge funds and other institutional traders is that they have more bargaining power. This increased bargaining power is due to their access to larger amounts of capital. Even comparatively small firms often manage far more than any retail trader. Once you take larger firms into account, the numbers become even more dramatic. According to HFR, in 2016, the total assets invested in hedge funds exceeded $3 trillion.
Hedge funds and other institutional traders use this capital to give them more bargaining power, which they can use to help them get lower execution costs, commission rebates, margin fees, etc. Institutions can complete trades at a lower cost than retail traders.
More Support Services
Hedge funds have access to support services and resources that retail traders don’t have. For example, these services may allow hedge funds to get differentiated research or access to better deals. Large amounts of capital and trading volume turn into revenue for the service provider. And often, the more considerable the hedge fund, the more reason there is to provide it with the absolute best support services to have the ability to keep working with them.
Wider Range of Financial Products
Institutional traders have access to more investment vehicles than a retail trader. For example, only institutional investors can invest in an IPO. For hedge funds, the difference is even starker. One of the defining features of a hedge fund is that it has considerably less regulation than other funds. One aspect of this reduced regulation is that hedge funds can invest in a broader range of financial products.
Top Quality Infrastructure
As we’ve seen, hedge funds have big money, and with that money comes the ability to purchase the leading technology. This technology may allow hedge funds to conduct research more efficiently, complete trades more quickly, and process information faster. On the other hand, the typical retail trader is often working with no more than a laptop.
Leverage is essentially the ability to trade on borrowed money. Retail traders can use leverage but at a cost higher than institutional traders. While leverage does come with added risk, it also comes with an ability to have a considerably higher return on your investment – especially with low interest costs. This serves to increase the purchasing power of institutions that may already have access to a large amount of capital.
Hedge funds, especially larger hedge funds, have access to far more information than a typical retail trader. This information may come in many different forms. It may be better researching capabilities, superior technology, etc. In comparison, retail traders often have far less access to information, even though all trades (at least all legal trades) are based on publicly available information. While technology and research come into play, the bigger issue for most retail traders is that they can’t compete with the amount of time devoted to accessing and analyzing the information compared to a hedge fund team.
Where Retail Traders Have the Advantage
At this point, you may be wondering how it’s possible for a retail trader even to consider the possibility of beating a hedge fund. Hedge funds indeed have many trading advantages, based mainly on their increased access to capital, but more capital isn’t always advantageous. In some instances, the smaller amount of capital and increased flexibility combine to provide creative retail traders with advantages that may give them the ability to beat even the biggest hedge funds. Specifically, we’ll look at the advantages that come from:
- Less Capital
- Less Regulation
- No Pressure to Use Capital
- No Investment Mandates
- No Disruptive Investor Withdrawals
At first, less capital may not sound like much of an advantage, especially when we’ve seen how more capital can be advantageous for hedge funds and other institutional traders. Still, the large amount of capital hedge funds work with can make trading more difficult in some instances.
One of the issues that come with managing large amounts of capital is that smaller markets with less liquidity can’t handle large influxes of money, and getting out of these markets can be incredibly difficult and costly. If a hedge fund invested in an illiquid market where few transactions occurred, they would significantly push the asset price, causing slippage and have a challenging time liquidating. These issues make it much harder for hedge funds to invest in these types of markets. And a lot of great opportunities exist there.
In a more illiquid market, you typically have fewer participants, fewer transactions occurring, less certainty regarding future performance. The result of these factors converging is that smaller, more illiquid markets are mispriced more often. This creates opportunities for traders to profit off of these securities. This is not to say that all illiquid markets are good investment opportunities, simply that they provide the potential for solid returns when analyzed correctly.
The ability to invest in these smaller, less liquid markets, while large hedge funds may not be able to, is a massive advantage for retail traders.
The ability to invest in smaller, less liquid markets is not the only advantage of working with smaller capital amounts. Another benefit is that it’s highly unlikely that a retail trader will move the market. On the other hand, a hedge fund very well may. When this happens, other traders may notice and follow suit. This can drive the price even higher. While a higher price may sound good in theory, if the rise in price happens rapidly, it can increase the fund’s entry price, reducing future returns.
Since a retail trader is trading with less capital, that trader can go in and out of positions with ease. Essentially, a retail trader can be far nimbler than a hedge fund.
Institutional traders, and even hedge funds, are still more regulated than a retail trader. When we think through why various financial regulations exist, this makes perfect sense.
The goal of most investment-related regulations are to protect investors. Regulations help ensure that money managers do not take advantage of the people whose money they manage. This isn’t as much of an issue with retail traders, since they’re only trading their own money.
There are a few ways this reduced regulation can benefit retail traders. Institutional traders often have various mandates that prevent them from investing in a certain asset class or security type. Retail traders often have more flexibility when trading in cryptocurrencies, stocks in developing countries, and unregulated derivatives.
It is worth pointing out that there is often a reason why regulations exist around these securities. Many of these securities come with incredibly high levels of risk. High risk is often correlated with the chance for higher returns, but high-risk investments should always be considered with caution. Retail traders are trading their own money. If they make a trade that exceeds the level of risk they can handle, they may end up losing a large amount of their portfolio.
No Pressure to Use Capital
This advantage and the next two we’ll look at are all about the additional flexibility retail traders have because they’re managing only their own money and not others. Plenty of advantages comes with managing others’ money, including access to more capital. Still, it also comes with more regulation, as we saw above, the need to meet investors’ expectations and the potential for disruption to your portfolio.
One significant advantage retail traders have over hedge funds, and other institutional traders are that retail traders are not under pressure to use their capital. If a retail trader does not think there’s currently a good opportunity, that retail trader can wait.
Hedge funds and other institutional traders often do not have the luxury of waiting for the right opportunity. Those invested in the fund are paying the fund manager to trade their money. This puts pressure on hedge funds to conduct trades. This pressure may result in funds trading in less than ideal scenarios.
Though this is undoubtedly an advantage for retail traders, it is reliant upon the retail trader’s patience. If the trader becomes impatient and makes trades for the sake of making trades, that trader is giving up a huge advantage he has over institutional traders.
No Investment Mandates
An investment mandate is a set of instructions that describe how a specific fund should be managed. An investment mandate typically describes the acceptable risk parameters and the investment strategy that the manager must implement. Funds, including hedge funds, usually have an investment mandate, but retail traders do not.
An investment mandate is helpful in some respects since it can help a fund manager make trading decisions, but it can also be limiting. If an opportunity arises for a hedge fund manager that is not in line with the investment mandate, the fund manager cannot make the trade.
Not having to follow an investment mandate gives retail traders considerably more flexibility. They can evaluate every trading opportunity based purely on the merits of that trade. This keeps them from being boxed into one trading strategy or passing on opportunities that exceed specific risk parameters.
Again, this is a benefit for retail traders only if they use it as such. If retail traders make trades haphazardly, with no rhyme or reason merely because they can, they are unlikely to have much success. Having a strategy is not a bad thing, but having the flexibility to adjust your strategy and risk parameters can be a huge advantage.
No Disruptive Investor Withdrawals
The final advantage we’ll touch on is that retail traders do not have to worry about disruptive investor withdrawals, but hedge funds do.
When an institutional investor wants to withdraw their capital, it can be quite disruptive. The investor’s holdings must be liquidated to raise the necessary cash. As we discussed previously if the assets are invested in an illiquid investment, this may be incredibly disruptive and may cause the hedge fund to have to execute the trade at a bad price, and there may be a large bid-ask spread. This is such an issue that some hedge funds have rules about how investors can withdraw their funds.
Retail traders do not have to worry about an inflow or outflow of capital that doesn’t benefit their portfolio. Since they are only trading their personal accounts, retail traders have full control over their portfolio and are not subject to the whims of investors whose money they’re managing.
Retail Traders Can Beat Institutional Traders
A retail trader beating a hedge fund or institutional trader may seem farfetched, but it is possible. And the instances of retail traders beating hedge funds are not limited to one or two outliers. Beating hedge funds isn’t easy, but especially lately, it’s become more and more possible.
Recently, the market volatility of 2020 has seen an increase in retail traders outperforming institutional traders. This is due, at least in part, to the performance of securities more popular among retail traders. This is not to say that this trend will necessarily continue. However, it clarifies that hedge funds, though more significant in size and often perceived as superior, may still be beaten by the little guy.
For me, the biggest takeaway is that retail traders shouldn’t attempt to beat hedge funds at their own game. When retail traders try to trade the same way as hedge fund does, they have little chance. The way retail traders can compete with and even beat a hedge fund is to think creatively and take advantage of all the benefits of being a retail trader.
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