Table of Contents
- What is an Institutional Investor?
a. Can an Individual be an Institutional Investor?
b. How do Institutional Investors Make Money?
c. Are Family Offices Institutional Investors?
- Types of Institutional Investors
a. Hedge Funds
b. Mutual Funds
c. Private Equity and Venture Capital
d. Insurance Company
e. Endowment Funds
f. Pension Funds
- Impact of Institutional Investors
a. Market Maker
b. Corporate Governance
- Advantages of Institutional Investors
a. Lower Fees
b. Access to Securities
c. Resources and Professional Guidance
In the world of finance, investors are typically categorised into two different groups: institutional investors who invest through entities, typically on others’ behalf, and retail investors who invest as individuals, typically for themselves. The investment strategies deployed by these two types of investors are different mainly due to their differing accesses to the financial markets and information.
In this article, we provide an insight into institutional investors by examining the various sub-types of institutional investors, the impact that they have in the market, and the advantages they have as opposed to retail investors.
What is an Institutional Investor?
An institutional investor is a legal entity or organisation that pools funds from numerous investors, such as retail investors or other legal entities, to invest in different financial instruments such as stocks, bonds, real estate, or other investment vehicles.
Institutional investors are considered sophisticated investors who possess extensive investment knowledge and experience. They are capable of in-depth analysis, including risk and returns forecasts, are able to develop sophisticated financial models, and typically have robust due diligence processes, hence they are less likely to make poor investment decisions compared to retail investors.
Institutional investors generally invest money on behalf of their members or clients and may also invest their own money, they also have access to private investment options not typically open to retail investors, such as institutional real estate, or private stock placements.
Retail investors, on the other hand, tend to be non-professional investors who trade in securities and funds, usually through intermediaries such as 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 size compared to institutional investors. Retail investors also tend to be less skilled and more susceptible to emotional biases compared to institutional investors.
Institutional investors typically follow clear objectives set out in the investment thesis, and have compliance and risk teams preventing deviations.
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Can an Individual be an Institutional Investor?
No, an institutional investor is a company or entity that invests capital on behalf of individuals. Individual or retail investors typically invest in publicly traded stocks for their own gains, while institutional investors invest in a range of different asset classes. Accredited investors, on the other hand, may be an entity or an individual, but need to meet specific financial criteria.
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How do Institutional Investors Make Money?
Since Institutional Investors are investing on behalf of others, returns from investments do not go directly to them. Institutional Investors make money from asset management fees charged for managing investments, or by taking a share of profits should investments make money.
Are Family Offices Institutional Investors?
Family Offices function similarly to Institutional Investors, investing and managing the assets for the family they represent. However, unlike Institutional Investors, they typically only cater to a single client (the family) and do not manage investments from other individuals.
Types of Institutional Investors
There are several different types of institutional investors in the market. Each type of institutional investor specialises in specific asset classes and follows their own investment strategies.
1) Hedge Funds
Hedge funds are one of the most well-known types of institutional investors in the financial world. Some of the world’s biggest hedge funds include Bridgewater Associate, AQR Capital Management, and Blackrock. 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 both long and short positions on various securities.
Hedge funds typically have strict requirements for their investors and are not usually open to retail investors. To invest with a hedge fund, an investor must be an accredited investor.
One distinctive characteristic of hedge fund investments is illiquidity. This means hedge fund investors are locked into the 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 losses. Hedge funds are hence considered to be 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 fund managers in the world.
Mutual funds are well-diversified funds that invest across different industries, sectors, and geographical markets. They are designed to mitigate the risk of capital losses for their investors through diversification. Mutual funds typically do not have entry requirements for investors and are open to individual or retail investors with a small minimum investment size. One attractive feature of mutual funds is their low barriers to entry and lower risk profile, making them well suited for beginner investors.
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3) Private Equity and Venture Capital
Private Equity or PE institutions are pooled investment funds that provide capital to private organisations who are not publicly listed. The duration of the investment is usually long and typically over 5 years, making the investment illiquid. Private Equity institutions typically only target high net worth individuals as their investor base due to the high minimum investment size, and are able to provide access to private companies that are under the radar.
Venture Capital (VC) is a form of private equity financing which typically provides funding to startups, early-stages, and emerging companies with high growth potential. The typical objective of a VC is to invest early with the objective of increasing the valuation of their invested startups through a series of funding rounds, with the ultimate aim of an IPO (initial public offering). Some well-known VCs include Sequoia Capital, Softbank, and Andreessen Horowitz, which have invested in successful startups such as Facebook, Airbnb, and Uber to name a few. Both PE and VC investments are deemed to be risky.
4) Insurance Company
An insurance company collects premiums from its policyholders regularly from the insurance products they sell, which are generally divided into life and non-life insurance policies. A part of the premiums collected is typically deployed into long-term investments to generate returns and to cover claim payouts. Some of the financial instruments invested in by these firms 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.
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5) Endowment Funds
Endowment funds are generally established by universities, hospitals, charitable foundations, or other non-profit organisations to manage their money, which typically come from donations and are not needed immediately. The income generated from investment activities is typically required to be used to finance the beneficiaries’ activities, such as to provide scholarships or to fund charitable events.
6) Pension Funds
Pension funds are funds established using monetary contributions from pension plans. The accumulated capital is typically allocated to income generating and stable investments, as the primary purpose of pension funds is to provide steady financial income for pensioners upon retirement.
Pension funds have low risk appetites and typically invest only in well-diversified funds, low-risk government bonds, large-cap stocks, and stable real estate assets. Some well-known examples of pension funds include the Central Provident Fund (CPF) in Singapore, Government Pension Fund of Norway, and the California State Teachers Retirement System.Sign Up at RealVantage
Impact of Institutional Investors
Institutional investors carry significant clout in the financial market and are able to exert large influence over the price dynamics of certain securities. They also own large portions of public listed companies - according to a study conducted by Harvard Business Review, institutional investors own around 80% of all stocks in the S&P 500 index, estimated to be around US$21.7 trillion. In addition, financial institutions such as Blackrock, Vanguard, and State Street are the three largest owners of most DOW 30 companies.
Institutional investors are crucial to financial markets as they provide capital to businesses and also create liquidity for the financial securities they trade in the market. Institutional investors also help to enhance market efficiency by improving management accountability and price discovery.
Besides economic contributions, institutional investors also play an active role in improving corporate governance practices. 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 retail investors. This practice has encouraged firms to adhere to the principles of good corporate governance for their operations.
In addition, institutional investors holding a large portion of shares have more power to hold management accountable for actions that undermine shareholders’ interests and welfare. With a large portion of shares and voting rights in the company, institutional investors are able to make constructive adjustments in the board’s composition when a 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.
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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 purchasing power, this enables them to negotiate better fees for each transaction and better terms on their investments. Fees such as marketing or distribution expenses may also not be charged to institutional investors.
2) Access to Securities
Institutional investors are able to gain access to exclusive investment opportunities. These transactions may require a large amount of capital, for example commercial real estate, currencies, and futures contracts, which retail investors typically do not possess.
Other transactions such as IPOs, forwards, and swaps are restricted to institutional investors because of the complexity and high-risk nature of the deals. Institutional investors are deemed to have the knowledge, experience, and ability to guard themselves against the risks. In the US, institutional investors are entitled to buy private placements under Rule 506 of Regulation D as accredited investors. Individual or retail investors may also gain access to exclusive investment opportunities through methods such as co-investing, for example individual investors may invest in institutional real estate opportunities through real estate co-investing.
3) Resources and Professional Guidance
Managers who manage institutional funds are generally experienced investment specialists. These experienced managers are less prone to emotions such as greed and fear as compared to retail investors. Emotions are one of the top reasons retail investors lose money. Moreover, institutional investors are also better equipped with various analytical tools and technology, allowing them to make more accurate financial analysis when reviewing investment options.
To sum up, institutional investors are large organisations that typically invest money on behalf of a pool of investors. There are many different types of institutional investors in the market which differ in terms of the amount of control, the level of risk tolerance, the level of liquidity, and the participation in their investments.
Institutional investors are vital to capital markets. They exert great influence and have considerable impact on all asset classes and markets, and 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 treatment and lower acquisition fees when purchasing securities in the primary financial market. As a result, they may be able to achieve better returns for their investments compared to retail investors.
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