Definition of Institutional Investors
Institutional investors are organizations that pool together funds from people and other bigger entities. They invest these funds on their clients’ behalf. Investments can be in the form of securities, movable and immovable property, bonds or any other investment asset which may create good returns. Such investors charge fees/commissions for the specialized services they render to their clients.
Types of Institutional Investors
There are primarily seven types of Institutional investors
- Definition of Institutional Investors
- Types of Institutional Investors
- Difference between Institutional and Retail Investors
- Importance of Institutional Investors
- Limitations of Institutional Investors
- Size, Regulation, and Control of Institutional Investors
A fund manager manages a mutual fund. Investors – general public or institutions, pool in their money in such funds and this money is then invested in securities. Investors get back the returns generated in the form of dividends and appreciation in the value of mutual funds. Mutual funds are categorized on the basis of their investments and allocations, and the biggest category is equity or stock funds. These funds are primarily classified on the basis of the size of companies they invest in- Large-cap, mid-cap, and small-cap. For example, ProFunds Nasdaq 100 Svc is a large-cap mutual fund, DF Dent Midcap Growth Fund is a mid-cap fund, and Virtus KAR Small-cap growth is a small-cap fund.
Hedge funds are similar to mutual funds. Investors pool in their money and a professional fund manager invests it. But such funds are more risky and aggressive, with a view to generating more returns. Other than securities, these funds can also invest in real estate, currencies, derivatives, and other alternative assets. Investors generally have to meet a certain net worth requirement to qualify for such funds. They often leverage i.e. borrow heavily to invest and hence are riskier. For example, Bridgewater Associates is one of the largest hedge funds in the US.
An endowment fund is an investment fund to be utilized for a specific need or purpose. Regular withdrawals from the invested capital are made for such a fund. Trusts, non-profit organizations, universities, churches, and hospitals generally use these funds. Donors to these funds can also specify the use of such funds. For example, Harvard University’s endowment fund valued at nearly $40 billion is the world’s largest academic endowment as of 2019.
Commercial Banks accept deposits from the general public and institutions against interest. They give out loans with this money in return for a higher rate of interest which is their earning. Commercial banks these days provide a host of other services also to retain and expand customer base. These services include treasury and cash management, private equity financing, transaction deposit services, etc. Examples like JP Morgan Chase, Citigroup, etc. are some of the well-known commercial banks.
A pension fund is a scheme that provides pension or fixed income after retirement. Also known as superannuation funds, they play a key role. They have a large pocket size and are big investors in the securities market. According to Morgan Stanley, pension funds held about US$20 trillion in assets worldwide as of 2008. In a “defined benefit pension fund”, a person receives a fixed guaranteed amount after retirement. Whereas in a “defined contribution plan’, a person receives an amount depending upon the fund’s performance. For example, CalPERS is one of the largest pension plans in the US.
Insurance companies collect premiums for policies they issue at fixed intervals of time. In the eventuality of the occurrence of the pre-defined event, they make a pay-out to the policyholder. The investment portfolio is used for pay-out. With regular premium collections, they have a big sum to invest in securities. So they are an important form of institutional investors. Companies such as Allianz Life and Prudential Financial are few of the well know insurance companies.
These funds are relatively newer than other forms of institutional investors. They too are pooled investment vehicles and provide equity financing to private entities. These entities may be small or newly set up and not in a position to raise capital from the general public. P/E Funds come to their rescue with capital investments. Because of small sizes of the investee and high-risk funding, investors expect high ROI. The Blackstone Group and Bain Capital are examples of successful P/E funds across the globe.
Difference between Institutional and Retail Investors
Retail investors are individuals investing in the market through traditional means or brokerage firms. These investments can be in equity shares, commodities, mutual funds or exchange-traded funds (ETFs).
Institutional investors too invest in similar products, but their volume is significantly higher. Their lot sizes can be blocks of 10000 shares or even more. But they avoid shares of smaller companies as there is a risk of investment getting stuck. Retail investors might find such smaller stocks more attractive with a chance of high returns.
Institutional investors operate in swaps and forward contracts too which are generally not touched by retail investors. They also enjoy lower transaction fees than retail investors. Due to their investment size, they bear much lesser marketing and distribution costs than retail investors.
Institutional investors are able to afford the services of specialists and experts. They have a better chance of making profits with their specialized skill sets and knowledge. On the other hand, retail investors are more prone to erring in investment decisions and losing their money. This is due to limited knowledge and the absence of averaging opportunities like institutional investors.
Importance of Institutional Investors
Prime Source of Capital
Economies are primarily dependent upon institutional investors for capital. Small investors can only invest limited money in companies. Institutional investors provide companies with a major chunk of capital. They play a key role at the time of IPOs of companies. Bulk buying from their side ensures that the IPO is well subscribed. They perform the majority of trades on exchanges globally. Due to their volume, they can influence the price of any security.
Economies of Scale
Institutional investors trade in big volumes. Hence they enjoy lower transaction costs, fees, and charges. Investors eventually benefit from this.
Professional management team with special skill sets enable institutional investors to take well informed and timed investment decisions. Small investors who have pooled in their money are able to enjoy higher returns. They do not directly bear the burden of heavy capital investment and its subsequent risk.
Limitations of Institutional Investors
There are a few limitations of such investors too.
High Volume, High Influence
Institutional investors buy and sell in bulk and hence can manipulate the price of any security to their advantage. Companies become highly dependent on such investors for their capital requirements. In case a big investor decides to pull out from a position, markets may perceive it as a negative signal against the company.
Few forms of institutional investors can face liquidity problems too. For example, an insurance company might see a sudden increase in the number of claims and pay-outs and this can severely affect its liquidity position. P/E funds mostly enter into time-bound investments, So they cannot withdraw before fixed maturity date.
Size, Regulation, and Control of Institutional Investors
According to McKinsey estimates, the North American Asset Management industry controlled more than $88.5 trillion at the end of the year 2017. Institutional Investors own about 80% of equity market capitalization in the United States.
Because of their big sizes and manipulative power, proper regulation and control are essential in any country. Countries like the USA have set up the Securities and Exchange Commission (SEC), Federal Reserve System (FED), Federal Deposit Insurance Corporation (FDIC), etc. to oversee and control their activities.
They create a win-win situation for themselves as well as smaller investors who invest in their funds by sharing their risks and providing high returns opportunities. Institutional Investors are of great advantage to economies and capital markets with a strict regulatory body.1,2