The financial market is a complex ecosystem hosting a large variety and number of components. It naturally comprises a diverse range of participants on either end of the spectrum as well. And the crowd of investors in it are no exception in that regard. Just as there are individual investors, the financial market also hosts a significant band called an institutional investor. This category of investors carries a critical role in the financial market owing to their distinct features as market players.
Meaning of Institutional Investor
An institutional investor is a company or organization that invests money on behalf of other people. Mutual funds, pensions, and insurance companies are examples. Institutional investors often buy and sell substantial blocks of stocks, bonds, or other securities and, for that reason, are considered to be the whales on Wall Street.The group is also viewed as more sophisticated than the average retail investor and, in some instances, they are subject to less restrictive regulations.
The Role of Institutional Investors
An institutional investor buys, sells, and manages stocks, bonds, and other investment securities on behalf of its clients, customers, members, or shareholders. Broadly speaking, there are six types of institutional investors: endowment funds, commercial banks, mutual funds, hedge funds, pension funds, and insurance companies. Institutional investors face fewer protective regulations compared to average investors because it is assumed the institutional crowd is more knowledgeable and better able to protect themselves. Institutional investors have the resources and specialized knowledge for extensively researching a variety of investment opportunities not open to retail investors. Because institutions are moving the biggest positions and are the largest force behind supply and demand in securities markets, they perform a high percentage of transactions on major exchanges and greatly influence the prices of securities. In fact, institutional investors today make up more than 90% of all stock trading activity.
Types of Institutional Investors
Any entity that collects funds from a number of sources to buy and sell securities is an institutional investor. By that understanding, there are five types of institutional investors in the market. These are:
Mutual Funds- It’s the most popular among this category. Mutual funds are vehicles facilitating investment in a variety of securities with capital commitment from several investors, both individual and otherwise. In other words, numerous entities invest their capital, which is pooled and in turn, invested in a bag of securities called mutual funds. Qualified fund managers handle each MF. Thus, individuals with a limited understanding of stock market dynamics can rely on this instrument to mobilize their disposable income. Nearly every mutual fund includes an array of liquid securities. Therefore, members can retract their investment anytime. Moreover, the securities invested via MFs usually span across several industries or types. It’s designed to minimize the risk of capital loss, wherein the gains from one dilute loss in another security kind.
Hedge Funds-Another popular instrument in line with institutional investor meaning is a hedge fund. It can be best described as an investment partnership where the money collected from members is pooled to invest in securities. Here, there’s a fund manager, who’s called the general partner, and a bevy of investors called limited partners. Its characteristics are somewhat consistent with mutual funds’, in that they are designed to reduce risk and enhance returns via a diverse portfolio. However, hedge funds distinguish themselves with more aggressive investment policies and are also more exclusive compared to MFs. Therefore, they are also perceived as riskier. Naturally, returns are even more substantial here.
Insurance Companies- Insurance companies are heavyweight institutional investors. These institutions employ the premium they receive from policyholders into securities. Since the aggregate of premiums is considerable, their investments are also sizable. The returns insurance companies receive from trading are deployed to pay for claims.
Endowment Funds- Endowment funds are set up by foundations, where the administrative/executive entity utilizes the funds for its cause. Typically, schools, universities, hospitals, charitable organizations, etc. establish these funds. Here, the investment usually acts as a deductible for the investor. These funds are so designed that the principal remains intact, and the controlling organization uses the investment income to finance its activities.
Pension Funds- Pension funds are also a popular form of institutional investors. Both an employer and an employee can invest in pension funds. The accumulated capital goes toward the purchase of different kinds of securities.
There are two kinds of pension funds –
- Where the pensioner receives a fixed sum irrespective of how the fund fares.
- Where the pensioner receives returns based on the performance of the fund.
Retail Investors vs. Institutional Investors
Retail and institutional investors are active in a variety of markets like bonds, options, commodities, forex, futures contracts, and stocks. However, because of the nature of the securities and the manner in which transactions occur, some markets are primarily for institutional investors rather than retail investors. Examples of markets primarily for institutional investors include the swaps and forward markets.
Retail investors typically buy and sell stocks in round lots of 100 shares or more; institutional investors are known to buy and sell in block trades of 10,000 shares or more.3 Because of the larger trade volumes and sizes, institutional investors sometimes avoid buying stocks of smaller companies for two reasons. First, the act of buying or selling large blocks of a small, thinly-traded stock can create sudden supply and demand imbalances that move share prices higher and lower.
In addition, institutional investors typically avoid acquiring a high percentage of company ownership because performing such an act may violate securities laws. For example, mutual funds, closed-end funds, and exchange-traded funds (ETFs) that are registered as diversified funds are restricted as to the percentage of a company’s voting securities that the funds can own.
FAQs
What are institutional investors?
Institutional investors are entities that pool large sums of money to invest in various financial instruments and assets. These entities typically include pension funds, mutual funds, insurance companies, endowments, hedge funds, banks, and sovereign wealth funds.
What distinguishes institutional investors from individual investors?
Institutional investors differ from individual investors in terms of the scale of their investments, their investment goals, and their regulatory requirements. Institutional investors often manage large portfolios on behalf of multiple beneficiaries or stakeholders, whereas individual investors manage their own investments.
What are the primary objectives of institutional investors?
The primary objectives of institutional investors are typically to generate returns on their investments, preserve capital, manage risk, and fulfill their fiduciary duties to their beneficiaries or stakeholders. They often have long-term investment horizons and may seek to achieve specific financial goals such as funding retirement obligations or supporting charitable activities.
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