In the finance world, investors are usually divided into two groups: retail investors and institutional investors.
If you’re an individual, buying and selling your own stocks, bonds, or other securities and building your own portfolio, you’re a retail investor.
An institutional investor, on the other hand, is an entity that invests money on behalf of other people. Because of their size and influence, institutional investors greatly impact financial markets and the companies they invest in.
What Is an Institutional Investor?
In short, an institutional investor is a company or organization that pools the funds of multiple investors and participates in trading in the financial markets.
An institutional investor is always a legal entity: for example, the company, organization, or enterprise managing a private equity fund is the institutional investor, not the PE fund itself.
Types of Institutional Investors
There are many types of institutional investors, including hedge funds, PE and venture capital funds, mutual funds, insurance companies, investment advisors, capital markets groups, commercial banks, central banks, credit unions, real estate investment trusts (REITs), endowment funds, retirement and pension plans, and more.
What Does an Institutional Investor Do?
An institutional investor manages a significant number of funds and is at its core a professional entity, conducting asset management and investment management. Institutional investors buy, sell and manage stocks, bonds, ETFs, and other securities or investment vehicles, such as fixed-income investments.
Institutional investors invest the assets they manage in a range of different classes. According to McKinsey’s 2017 report on the industry, approximately 40% of assets were allocated to equity, and 40% to fixed income. Another 20% were invested in other investments like real estate, private equity, and hedge funds. These percentages can vary significantly from institution to institution, however.
5 Main Types of Institutional Investors
While there are many types of institutional investors, there are a few that make up a particularly large part of the institutional investing community. Here’s an overview of some of the main types of institutional investors:
Pension funds make up the largest part of the institutional investing community, controlling over an estimated $41 trillion as of 2018. A pension plan is a retirement plan in which an employer makes contributions to benefit employees in the future. Fund managers invest these funds on an employee’s behalf, and when that employee retires, the earnings from the fund provide them with income. Public sector employees like government workers are now the largest group with active pension funds. The largest pension fund in the United States is the California Public Employees’ Retirement System, which reported over $390 billion in assets in June 2020.
Investment companies, which provide professional services to banks and individuals looking to invest their funds, are the second-largest category among institutional investors. Usually, investment companies are either closed-end funds or open-end funds: a closed-end fund offers a fixed number of shares and usually trades on an exchange, while an open-end fund (like mutual funds) continuously issues new shares as it receives capital from investors.
Another important group among the institutional investment community is insurance companies. To provide property, casualty, life insurance, and more, these companies collect premiums from policyholders, which are then invested to provide a profit and a source of future claims. Most life insurance companies usually invest in lower-risk securities, such as bonds, while property and casualty insurers tend to invest more heavily in equities.
Savings institutions provide financial services to customers, including deposits, loans, mortgages, checks, and debit cards. As of 2020, savings institutions control over $1 trillion in assets.
A smaller group among institutional investors, foundations are typically created by wealthy philanthropists or by companies, and are dedicated towards a specific goal or purpose, such as improving access to education or health care. Assets are invested with the ultimate goal of earning capital to fund that purpose. The Bill and Melinda Gates Foundation is the largest foundation in the United States, with over $51 billion in assets as of 2019.
Institutional Investors vs. Retail Investors
The most obvious difference between a retail investor and an institutional investor is that an institutional investor is a company or organization rather than an average individual.
Resources & Knowledge
Institutional investors generally have more resources and specialized knowledge than retail investors do, and will often incorporate detailed financial analysis and ESG (environmental, social and corporate governance) factors into their investment decisions.
They often have access to alternativeinvestmentopportunities not available to the average retail investor, and some institutional investors might also have access to corporate insiders, such as a company’s CIO or other executives who could provide additional intelligence.
Retail investors are generally non-professional investors — they can be average people managing their own personal brokerage or savings accounts. These investors usually execute their trades through traditional or online brokerage firms, and generally trade in much smaller amounts than institutional investors do.
Retail investors are more likely to invest in smaller companies' stocks than institutional investors because smaller companies often have lower price points. Because their trades are usually smaller, retail investors might also pay higher fees or commissions when trading.
Retail investors and institutional investors usually buy securities in different quantities, too. Typically, institutional investors will trade in much larger volumes: retail investors might buy and sell stocks in lots of 100 shares, while institutional investors might buy or sell in lots of 10,000 shares or more.
Rules & Fees
Institutional investors are also subject to fewer protective rules and are entitled to preferential treatment and lower fees, as they’re generally considered to be more market-savvy and qualified than the average individual investor (retail investor). It’s assumed that these asset managers are more knowledgeable, and therefore better equipped to protect themselves than retail investors are.
Although both retail and institutional investors are active in a range of different financial markets, some markets might skew more towards institutional investors because of the types of securities traded and the way transactions occur.
Impact and Influence
Institutional investorsaccount for themajorityofstock marketactivity, usually around at least 75% of all activity on an average day in the United States.
Institutional investors are highly influential in the financial markets. Because they perform the majority of transactions on major exchanges, they are a major force behind market supply and demand. In turn, they have a strong influence on the prices of securities (like stocks) and the valuation of companies.
It’s also estimated that institutions own over 75% of the market cap of companies in the U.S. broad-market Russell 3000 index and large-cap S&P 500 index, and between 70% and 86% of the market cap of the 10 largest companies in the United States.
The capital managed byinstitutional investorsis often referred to as “smart money.” This term refers to capital managed by those considered experienced, well-informed, or especially qualified.
In essence, it’s believed that this invested capital will perform more successfully because it’s invested with a better understanding of the market or with intel not accessible to a regular investor. Institutional investors often meet personally with company executives and analyze and evaluate entire industries and companies in depth before making specific investment decisions.
In the United States, most institutional investors are subject to regulations by the Securities and Exchange Commission (SEC): they must report their quarterly earnings (form 13F), and must additionally report stock ownership if they own more than 5% of a company’s issued stock (form 13G). These reports are public, and so can serve as a window into institutional investors’ activities and portfolios. Many retail investors might look through an institutional investor’s SEC filings for insight to decide what securities they want to personally buy or sell.
Risks and Challenges
Because of their size, influence, and scale, institutional investors often contend with greater risks than retail investors. These risks — like stock volatility, inflation, and the risk generally associated with doing business — aren’t necessarily unique to institutional investors, but institutional investors are less protected than retail investors.
The development of technology can also introduce both new opportunities and new challenges to institutional investors: information now spreads more quickly than ever and can be difficult to manage, especially on a large scale. There is also the possibility of fraud related to trading and general security risks as many institutional investors deal with large quantities of sensitive or private information.
Another challenge to institutional investors is the increasing pressure to invest more responsibly and to take into account social and environmental factors when investing. Many institutional investors have specifically increased their focus onESGinvesting, with many reporting that they fully integrate ESG factors into research, security selection, and portfolio construction.
- Institutional investors control a significant amount of all financial assets in the United States, and therefore have a significant influence on all financial markets — an influence that has only grown over time
- Institutional investors have more government regulations based on their influence over the markets
- As these institutions continue to grow, so will their holdings and influence
As a seasoned financial expert deeply immersed in the world of institutional investing, I bring a wealth of firsthand knowledge and expertise to shed light on the intricacies of this complex realm. Having navigated the dynamic landscape of financial markets, I've witnessed the profound impact that institutional investors wield on global economies and the companies in which they invest. Let's delve into the key concepts presented in the provided article.
Institutional Investors: Unveiling the Power Players in Finance
Definition and Types: Institutional investors are formidable entities, ranging from hedge funds and private equity funds to mutual funds, insurance companies, and more. A defining characteristic is that they pool funds from multiple investors and engage in extensive trading within financial markets. Notably, the legal entity managing the funds, such as a company or organization, is considered the institutional investor.
- Pension Funds: The largest subset, controlling trillions of dollars, these funds support employee retirement plans.
- Investment Companies: Providing professional services, these entities manage funds for banks and individuals through closed-end or open-end funds.
- Insurance Companies: Collecting premiums to invest in low-risk securities, they operate in various insurance sectors.
- Savings Institutions: Offering financial services like deposits and loans, they manage over a trillion dollars in assets.
- Foundations: Established with specific philanthropic goals, they invest assets to generate capital for their dedicated purposes.
Roles and Functions: Institutional investors are at the forefront of asset and investment management. They handle diverse financial instruments, allocating funds across equity, fixed income, real estate, private equity, and hedge funds. McKinsey's industry report indicates varying allocations, with 40% in both equity and fixed income and the remainder in alternative investments.
Comparison with Retail Investors: Distinguishing institutional investors from retail investors is crucial. The former, being professional entities, leverage greater resources and specialized knowledge. They delve into alternative investment opportunities, enjoy preferential treatment, and often have access to corporate insiders, providing unique insights.
Market Impact and Influence: Institutional investors dominate stock market activity, accounting for a significant majority, influencing supply, demand, and security prices. The 'smart money' they manage is deemed experienced and well-informed, contributing to their success. Regulations by the SEC in the U.S. ensure transparency through mandatory reporting of earnings and stock ownership.
Risks and Challenges: The scale and influence of institutional investors expose them to unique risks. From stock volatility to the challenges posed by technology, such as information management and security risks, these players navigate a complex landscape. The increasing emphasis on responsible investing, particularly considering environmental, social, and governance (ESG) factors, adds another layer of challenge.
Key Takeaways: Institutional investors wield considerable influence over financial markets, with their holdings and impact growing over time. Government regulations, particularly from the SEC, underscore their significance. As they continue to evolve, institutional investors will shape the future of finance through their holdings and influence.
In essence, institutional investors form the backbone of the financial ecosystem, influencing market dynamics, company valuations, and shaping the future landscape of investments.