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What's Driving the Big Money to Buy?

By Alexander MacLennan - Sep 26, 2013 at 5:07PM

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Fund managers are buying for reasons besides future returns.

Institutional buying is often seen as a bullish sign as average investors believe that the "smart money" is getting behind a stock. But institutions have more goals than simply generating high returns: They have to generate and retain clients. In doing this, many have resorted to a practice known as window dressing to make their portfolios look better. So what is window dressing and why does it matter? Let's take a look.

Window dressing
Although the people investing in large funds expect that fund managers will earn them the best return on their investments, the same people also tend to like seeing all-star stocks listed as part of the fund.

This has led fund managers to buy popular stocks in a management style known as "window dressing." When a stock shoots higher like Tesla, investors like to see it in their fund, even if it does not become the most profitable investment. Since fund managers tend to make more money if they manage more money, it's in their financial interest to impress clients by showing off a popular stock.

Popular investments
For fund managers to window dress a fund with a stock, it has to be a stock popular with investors. But other characteristics are needed as well. Let's see which of these three tech companies have them.

CompanyPrice to FY2013 EPSInstitutional OwnershipInstitutional Activity (Past 3 Months )YTD Stock Perfromance
Amazon.com (AMZN -0.99%) 370 times 68.7%

Net buyers: -14

Net shares purchases: 2.1 million

+25%
Netflix (NFLX 2.96%) 206 times 94.7%

Net buyers: 22

Net shares purchased: 6.2 million

+231%
Tesla Motors (TSLA 0.78%) 299 times 60.5%

Net buyers: 43

Net shares purchased: -9.1 million

+438%

First of all, we can see that institutions are willing to pay a high valuation (based on earnings) for these growth companies. This is not necessarily a bad thing. Often, the best companies with the brightest futures cost more than their less advantaged rivals.

But what we do notice is a major inflow of funds into the two highest-performing stocks listed above. Window dressing is more than just picking the popular stocks; it also involves picking high-performing stocks fund investors know about. As Tesla and Netflix have been rising, institutions have been pouring money into them to show their clients that their fund contains high performers. Despite the 9 million net shares of Tesla sold, the huge run-up in the stock forced a lot of funds to rebalance their portfolios to avoid becoming too heavily weighted in Tesla. Net buyers for Tesla were still strong showing institutions are still generally purchasing the stock.

Institutions are more neutral on Amazon.com, where shares have "only" climbed 25% this year. Amazon shows how growth potential is not enough to attract window-dressing institutional buyers. With Tesla and Netflix, funds can show off past stock performance and attract clients with today's supposed hot stock. Amazon lacks this multibagger past performance to show off, making Tesla and Netflix better picks for funds looking for window dressing.

How bullish is this buying?
Institutional buying is generally seen as a bullish sign by retail investors. The perception is that institutions have the smartest investment gurus and when they start buying, you should, too. But many funds are trying to serve multiple interests. On one hand, they want to provide the best returns. But on the other hand, many try to keep clients interested with holdings in top hot stocks.

Average investors should realize that institutional buying is not just a green light to buy in an effort to follow the supposed "smart money." While there are many arguments for and against buying shares of Amazon, Netflix, or Tesla, institutional buying has to be taken with a grain of salt. While competing funds try to show off hot stocks while generating strong returns, average investors who fully research their holdings have no need to balance their portfolios to incorporate hot stocks that can be showed off.

If you are interested in shares of Amazon, Netflix, Tesla, or any other hot stock, you should do your own research instead of jumping after institutional buying. Institutions have many objectives to meet, but your portfolio only needs to make your expected rate of return.

All institutional data from Reuters.com.

Alexander MacLennan owns shares of Tesla Motors. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool recommends and owns shares of Amazon.com, Netflix, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Netflix, Inc. Stock Quote
Netflix, Inc.
NFLX
$233.49 (2.96%) $6.71
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$139.41 (-0.99%) $-1.39
Tesla, Inc. Stock Quote
Tesla, Inc.
TSLA
$871.27 (0.78%) $6.76

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