What Are Institutional Investors?
An entity pools money from various investors and individuals making the sum a high amount which is further provided to investment managers who invest such huge amounts in various portfolio of assets, shares, and securities, which is known as institutional investors and it includes entities like insurance companies, banks, NBFC, financial institutions, mutual funds, etc. having competitively higher creditworthiness and solvency.
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Source: Institutional Investors (wallstreetmojo.com)
Institutional Investors usually have their own teams looking at each aspect of the markets that they trade in. They enjoy less regulatory protection because they have enough knowledge to understand the risk of the markets. The 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.
Table of contents
Key Takeaways
- Institutional investors pool money from multiple investors and individuals, allowing large capital amounts to be invested in various assets and securities.
- Examples of institutional investors include insurance companies, banks, mutual funds, pension funds, and hedge funds.
- Institutional investors often have dedicated teams that analyze and trade in different markets, benefiting from their expertise and allowing them to navigate risks effectively.
- The term “Elephant” is commonly used to describe an institutional investor that can independently influence the market due to the large volumes of trades they execute.
Institutional Investors Explained
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 investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more.
Domestic and foreign 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.
Types
Domestic institutional investors form a major part of the market’s movement and the volume of trades. Let us understand in depth about the types through the discussion below.
Type #1 – Hedge Funds
This type of Institutional Investors is 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 PartnerGeneral PartnerA general partner (GP) refers to the private equity firm responsible for managing a private equity fund. The private equity firm acts as a GP, and the external investors are limited partners (LPs).read more 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 AssetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet.read more. The most important characteristic of the Hedge FundHedge FundA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more 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 Mutual Funds A mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more 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 of the benefit of getting professional management of their funds through this fund. The investment is made in liquid assets that are traded in the market.
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 EquityPrivate EquityPrivate equity (PE) refers to a financing approach where companies acquire funds from firms or accredited investors instead of stock marketsread more funds are pooled investment vehicles with a structure of a Limited Partnership and a fixed term of usually ten years. These funds provide equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more 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 capitalVenture CapitalVenture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. read more 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 a 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 investor 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 incomeInvestment IncomeInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read more, 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 often paid irregularly. The premium that they earn needs to be deployed, and hence they invest in securities.
The claims are paid out of this investment portfolioInvestment PortfolioPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor's risk profile.read more. Since the size of insurance companies is generally large, the size of their investments is also large.
Examples
Let us understand how foreign and domestic institutional investors invest funds on behalf of other players in the market with the help of a couple of examples.
Example #1
ABC Mutual funds started off as a small firm. However, their somewhat unconventional strategies such as momentum strategy gained them a reputable name in the industry. With $75 million in Assets Under Management (AUM) they invest in a variety of funds.
They also have catered to different types of clients based on risk appetite, time frame, and even personal preferences such as investing exclusively in green investments, or a particular sector.
Example #2
In 2020 after the pandemic hit the world, investors began looking for rebalancing their portfolios and overall investment styles. This led to domestic and foreign institutional investors looking at gold as a good alternative to hedge against equity.
Gold is looked at as a good hedging commodity as its growth has been second to none historically. The precious metal’s holding in institutional portfolios has seen an incredible hike, especially after the Russia-Ukraine war.
Large institutions with over $10 Billion in AUM have increased their holding in gold by 15% to rebalance their portfolios and deliver good returns for their clients.
Importance
Domestic and foreign institutional investors are pivotal sources of capital and also provide the volume of trades for the markets to thrive. Let us understand their importance through the points below.
- Important Sources of Capital – Institutional Investors are a very important source of capital in the economy. They provide large chunks of capital to companies that 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 IPOIPOAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more 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 moneyManagement Of Their MoneyMoney management refers to the proper use of money, which includes creating a budget, understanding cash expenses and incomes, tracking the money spent, saving some income for investment and future use, eliminating unnecessary expenses, and keeping track of all items to understand cash spending and generation.read more.
- Preferential Treatment – Since Institutional Investors can influence the market because of their large size of investments, they get preferential treatment in terms of lower transaction 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
Domestic institutional investors have an undie advantage over the market and sometime they can be at a position where an advantage can be taken. Let us understand the criticisms or issues with such investors through the explanation below.
- 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 the 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.
Frequently Asked Questions (FAQs)
Institutional investors bring several benefits to the market. They provide significant capital, allowing companies to access larger funding without relying solely on retail investors. Institutional investors often have teams of experts who analyze markets and securities, providing professional management to investors. They also enjoy preferential treatment, such as lower transaction costs and faster execution, due to their large size and influence in the market.
While institutional investors offer advantages, there are also risks to consider. Their large size and influence can lead to market manipulation, as their entry or exit from positions may impact security prices. Additionally, their decisions to exit investments can signal caution to the market, potentially affecting prices.
Private investors are individuals or small groups investing their capital in various assets. They typically have smaller investment portfolios and may be less experienced or knowledgeable in financial markets. On the other hand, institutional investors are entities that pool money from multiple investors and deploy it in the market. They include insurance companies, banks, mutual funds, pension funds, and other organizations that manage large amounts of capital on behalf of their clients or members.
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