Institutional Investors Definition
Institutional Investors are large institutions that trade securities in the market in large quantities on behalf of their investors. Since the number of investors in such an entity is large, the size of the trades is automatically large and are able to enjoy preferential treatment and lower commissions in the market as compared to the retail investors.
Institutional Investors usually have their own teams looking at each aspect of the markets that they trade-in. They enjoy fewer regulatory protection because they have enough knowledge to understand the risk of the markets and act accordingly. A commonly used term, Elephant, refers to an Institutional Investor that has the ability to influence the market by itself because of the large quantities that it trades.
Types of Institutional Investors
The common types of Institutional Investors include the following:
Type #1 – Hedge Funds
This type of Institutional Investors are investment funds that pool in money from various investors and invest on their behalf. They are usually structured as limited partnerships with the fund manager acting as the General Partner and the investors acting as Limited Partners. The distinctive features of hedge funds are that there is no limit imposed by the regulators on the usage of leverage.
Also, they invest mostly in Liquid Assets. The most important characteristic of Hedge Funds is that it often takes a long and short position or a hedged position in securities. They also use numerous other risk management techniques for neutralizing the risk.
Type #2 – Mutual Funds
Mutual Funds are pooled investment vehicles that buy securities with capital pooled in by multiple investors. The main advantages of Mutual Funds are that they are professionally managed.
Investors without any proper knowledge can avail the benefit of getting professional management of their funds through this fund. The investment is done in liquid assets that are traded in the market.
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Mutual Funds are well diversified and provide investors protection in case particular security underperforms. At the same time, mutual funds charge some fees to every scheme which is deducted from the client’s account.
Type #3 – P/E Funds
Private Equity funds are pooled investment vehicles with a structure of a Limited Partnership and a fixed term of usually 10 years. These funds provide equity financing to private entities that are unable to raise capital from the public. These investments are illiquid in nature.
P/E funds often indulge in venture capital financing, wherein they provide capital to up and coming entities in which they see the huge hidden potential. The minimum investment size with P/E funds is usually high and this option is available to only HNIs.
P/E funds carry high risk and therefore investors expect a high return on their investment. The high risk is associated with the non-public nature and small size of the investee companies.
Type #4 – Endowment Funds
This type of institutional investors is investment pools established by a group of founders or principals for specific needs or for the general operating processes of an entity. They often take the form of Non-Profit Organisations and foundations.
They are generally used by universities, hospitals, and charitable organizations where the principals make donations to the fund. The investment income, as well as a small part of the principal, is available to the organizations for use.
Type #5 – Insurance Companies
Insurance Companies also fall under the category of Institutional Investors. They collect premiums regularly and the claims are paid often irregularly. The premium that they earn needs to be deployed and hence they invest in securities.
The claims are paid out of this investment portfolio. Since the size of insurance companies is generally large, the size of their investments is also large.
Importance of Institutional Investors in the Market
Following are the importance of institutional investors.
- Important Sources of Capital – Institutional Investors are a very important source of capital in the economy. They provide large chunks of capital to companies which fulfill their requirements without having to depend on a large number of small investors. Often before an IPO, investment banks ask institutional investors to buy the shares in order to ensure that the IPO is well subscribed. It reduces their dependency on retail investors.
- Benefits to Individual Investors – Institutional Investors have just pooled investment vehicles wherein a number of investors pool their money to form a large size entity that can invest on their behalf. Since not all investors are able to take positions in securities that require large capital commitments, they can enjoy those benefits through institutional investors. Also, they have their own teams of highly qualified personnel that study the securities and track the markets. They have professional management at every level. Individual Investors who lack all these skills get the benefit of highly knowledgeable expert management of their money.
- Preferential Treatment – Since Institutional Investors can influence the market because of their large size of investments, they get preferential treatment in terms of lower transactions costs, fast execution of their orders, etc. This saves time and money and ultimately benefits the investors who are a part of the investment pool.
Issues with Institutional Investors
Here we will discuss the issues related to institutional investors.
- High Dependency – As we mentioned before, Institutional Investors provide large chunks of capital to companies that reduce their dependency on retail investors. But at the same time, it increases their dependency on Institutional Investors. If they decide to exit a position, it may severely impact the price of that security since market might perceive that as a warning sign.
- Influence in Market – Institutional Investors hold a huge amount of influence in the market since they can manipulate the prices of security by entering or exiting a position in that security. They can sometimes use this influence to move the market or the price of a particular security in their favor.
Institutional Investors form an important part of the capital markets. They can influence the market by taking or exiting positions in any security. They provide a high amount of capital to various entities in the market. The dependency on them might be high in some cases which might lead to the company bending to their demands.
The regulator ensures that these powers are not exploited and keeps them in check in order to have a fair and transparent market for all participants.
This has been a guide to Institutional Investors and its definition. Here we discuss the types and importance of institutional investors along with the issues related to it. You can learn more about Asset Management from the following articles –