Table of Contents

What is an Institutional Investor?
Types of Institutional Investors
- Hedge Funds
- Mutual Funds
- Private Equity and Venture Capital
- Insurance Company
- Endowment Funds
- Pension Funds
Impact of Institutional Investors
- Market Maker
- Corporate Governance
Advantages of Institutional Investors
- Lower Fees
- Access to Securities
- Resources and Professional Guidance
Conclusion


In the world of finance, investors make investments by providing capital to business ventures for the purpose of earning financial returns at some point in the future. Typically, investors are categorised into two different groups: institutional investors who invest in the form of entities and retail investors who invest as individuals. The investment strategies deployed by these two types of investors are different owing to the fact that they both have different access to the financial markets and information.

In this article, we provide a deeper insight into the institutional investors by examining the various sub-types of institutional investors, the impacts that they have in the market and the advantages of institutional investing.

What is an Institutional Investor?

An institutional investor is a legal entity or organisation that pools funds from numerous investors (which may be individual investors or other legal entities) to invest in different financial instruments such as stocks, bonds, real estate, or any other investment vehicles.

Institutional investors are considered sophisticated investors who possess extensive knowledge and experience. They are capable of making sophisticated financial models which include a great deal of data for risk and returns forecasts coupled with a robust due diligence process and therefore, less likely to make poor investment decisions compared to individual investors. Institutional investors generally invest money on behalf of their members or clients and typically also invest with their own money as skin in the game.

Retail investors, on the other hand, are non-professional investors who trade in securities and funds, usually through intermediaries like brokerage firms or investment accounts managers provided by banks. Since these retail investors are investing on behalf of themselves rather than an institution, the investment amount tends to be much lower in quantum size compared to institutional investors. Due to the nature of the investment, retail investors tend to be less skilled and more susceptible to emotional judgment rather than following clear objectives set out in the investment thesis used by institutional investors..

Types of Institutional Investors

Types of Institutional Investors

There are several different types of institutional investors in the market. Each institutional investor specialises in their own asset classes and investment strategies. In general, there are six types of institutional investors:

1) Hedge Funds

Hedge funds are one of the most popular types of institutional investors in the financial markets. Some of the world’s biggest hedge funds include Bridgewater Associate, AQR Capital Management, and Blackrock, etc. As the term suggests, a hedge fund’s fundamental objective is to ‘hedge’ against losses in the overall stock market. This is often done by taking a long and short position on a certain security.

Hedge funds have strict entry requirements for their investors and are typically not open to retail investors. To invest with a hedge fund, an investor must be validated as an accredited investor and have at least $1 million in net worth.

One distinctive characteristic of hedge fund investments is that they are typically illiquid. This means hedge fund investors are locked into the high-risk investment for a longer period of time without the freedom to cash out and exit. In addition, hedge funds typically use a concentrated investment strategy, where funds are directed to a few assets in larger proportions, making it more susceptible to larger gains and also potential losses. As a result, a hedge fund is considered by many investors as a more aggressive and riskier investment asset class.

2) Mutual Funds

A Mutual fund is another common investment vehicle in the market. The underlying instruments of these vehicles are largely made up of a variety of stocks, bonds, funds, or other securities. Most mutual funds invest in liquid securities that are traded in the stock market. Vanguard, JP Morgan, and Fidelity Investments are some of the most famous mutual funds in the world.

Mutual funds are well-diversified funds that invest across different industries, sectors, geographical markets and even companies with different capitalisation sizes from small to large. They are well designed to mitigate the risk of capital for their investors by diversification. Mutual funds do not have entry requirements for investors and are open to individual investors with a small entry point. One attractive feature of mutual funds is that they are professionally managed by market experts; thus, it is well suited for beginner investors.

3) Private Equity and Venture Capital

Private Equity or PE institutions are pooled investment funds that provide capital to private organisations that are unable to raise capital from the public. The duration of the investment is usually long typically over 5 years; thus, making the investment illiquid for short- and medium-term investors. Private Equity institutions typically only have high net worth individuals as their investor base due to the high minimum investment size and private access to companies that are under the radar.

Venture Capital (VC) is a form of private equity financing and they typically provide funding to startups, early-stages, and emerging companies with remarkably high growth potential. Due to the nature of their investments, they are deemed to be risky. The typical objective of a VC is to invest early hoping to increase the valuation of their invested startups through a series of funding rounds with the aim of an IPO (initial public offering) as a listed company. Some of the well-known VCs include Sequoia Capital, Softbank and Andreessen Horowitz which have invested in successful startups that include the likes of Facebook, Airbnb and Uber to name but a few.

4) Insurance Company

An insurance company collects premiums from its policyholders regularly from the insurance products that they sell which generally are divided into life and non-life insurance. A part of the premiums collected is deployed into other long-term investments to generate returns for cash flow and to cover claim payouts. Some of the financial instruments that are invested in by these firms typically include inflation-hedged bills, government bonds or long-duration bonds.

Some of the world’s largest insurance companies include Axa S.A. Insurance, Prudential PLC, and Allianz SE.

5) Endowment Funds

Endowment funds are generally established by universities, hospitals, charitable foundations, or other non-profit organisations. The fund manager of these endowment funds is responsible for making investment decisions for these funds. The income generated from investment activities is obligated to be used to finance the core purpose of the fund which may include ESG (economic, social and governance) impacts.

6) Pension Funds

Pension funds are monetary contributions from pension plans put together by both employers and employees. The accumulated capital is allocated to different kinds of securities. The primary purpose of pension funds is to provide its steady financial income for the investors upon their retirement.

Pension funds are extremely low risk and invest only in well-diversified funds, low-risk government bonds and may include a small percentage of large-cap stocks. Some well-known examples of pension funds include the Central Provident Fund (CPF) in Singapore, Government Pension Fund of Norway and California State Teachers.

Impact of Institutional Investors

Market Maker

Market markers deal mainly in the financial markets buying/ selling /issuing new securities for secondary market trading. Hence, their presence in the financial market is notable. They carry significant clout in the financial market and are able to exert large influences over the price dynamics of certain securities. They are also known to own a large portion of public listed companies in the market. According to a study conducted by Harvard Business Review, institutional investors own around 80% of all the stocks in the S&P 500 index. In dollars term, that is estimated to be $21.7 trillion. In addition, financial institutions such as Blackrock, Vanguard, and State Street are the three largest owners of most DOW 30 companies.

Index Institutional Ownership

In short, institutional investors are crucial to the financial market because they ensure that the capital market is functioning well by providing adequate capital to businesses and supplying substantial liquidity as they help create and actively trade the plethora of financial securities in the market which will have a great impact on the ‘flow of money’ as well as the overall economy. Institutional investors also help to enhance market efficiency by improving management accountability and price discovery.

Corporate Governance

Besides economic contributions, institutional investors also play an active role in improving corporate governance in the financial market. According to a research paper written by Stephen Bainbridge, a Professor of Business Law at UCLA, institutional investors have greater incentives to develop expertise in tracking and monitoring their investments due to large monetary commitments when compared to individual investors. This practice has encouraged public firms to adhere to the principles of good corporate governance for the operation of companies of various sizes.

In addition, institutional investors holding a large portion of shares can have more power to hold the management accountable for actions that undermine shareholder welfare. With a huge portion of shares and voting rights in the company, institutional investors are able to make constructive adjustments in the board’s composition when the company’s performance diminishes.

In other words, institutional investors provide not only funds but also practical recommendations, networks, and support, which can be valuable to the companies that they invest in.

Institutional Investors Compliance

Advantages of Institutional Investors

1) Lower Fees

In most cases, institutional investors tend to trade on high-volume shares and only engage in large transactions, i.e., block trades of 10,000 shares or more with a significant amount of capital. Because of their large size and massive purchasing power, it enables them to negotiate better basis point fees for each transaction and the terms on their investment. Fees such as marketing or distribution expense ratios are also not charged to institutional traders.

2) Access to Securities

Institutional investors are able to gain access to many exclusive investment opportunities that individual investors do not. These transactions typically require large minimum buy-ins like commercial real estate, currencies, and future contracts.

Other transactions such as IPOs, forwards, and swaps are restricted because of the complexity and high-risk nature of the deals. Institutional traders are deemed to have the knowledge, experience, and ability to guard themselves against the risks. For these reasons, they may be exempted from certain regulations. In the US, institutional investors are entitled to buy private placements under Rule 506 of Regulation D as accredited investors.

This has allowed Institutional investors to obtain better investment prospects and achieve better-than-average market returns.

3) Resources and Professional Guidance

Small Investors Don't Always Choose Well

Managers who manage institutional funds are generally experts specialised in financial investment. These experienced managers are less prone to emotions such as greed and fear when compared to retail investors. Such emotions are one of the top reasons retail investors lose money. Moreover, institutional investors are also better equipped with various analytical tools and advanced technology, allowing them to make a more accurate financial analysis when reviewing investment options.

Conclusion

To sum up, institutional investors are large organisations that invest money on behalf of a pool of investors. There are many different types of institutional investors in the market. They tend to differ in terms of the amount of control, the level of risk tolerance, the level of liquidity, and the participation in the entity.

Institutional investors are vital to the capital markets. They exert great influence and considerable impacts on all asset classes and markets. They are also known to improve corporate governance and information transparency in the corporate world.

Since institutional investors often take part in large transactions, they may enjoy preferential treatments and lower acquisition fees when purchasing securities in the primary financial market. As a result, they are able to achieve better returns for their investments compared to retail investors.

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