The ChoosaBroker Trading Academy

3.5. Institutional Investors

Institutional investors represent the “smart money.” They buy and sell huge chunks of assets and exert tremendous influence on market prices. Mimicking their trades may not always be a good idea. But retail traders should track their market activity to get a broad sense of the direction and sentiment that is dominant at any given point of time. In this lesson, we will learn:

Who are Institutional Investors?

An institutional investor is an organisation or an entity which uses either its own capital or pooled-funds to trade and invest in financial assets like stocks, bonds, commodities, Forex and real estate. The vast majority of such investors are specialised bodies that manage savings collected from small investors, and work with specific objectives in terms of return maximisation, risk tolerance, and maturity of claims. Investment institutions include pension funds, sovereign funds, insurance companies, mutual funds, hedge funds and non-profit endowments.

Types of Financial Institutions

  • Pension Funds Pension funds collect funds from sponsors and beneficiaries and invest them with the mandate to providing future pension entitlements to the members. Pension funds can be managed either internally or externally. Returns to the said beneficiaries may be purely market-linked (defined contribution funds) or may be covered by a guaranteed rate (defined benefit funds). The latter also often have insurance features linked. These include guarantees in the event of the sponsor going bankrupt, as well as potential risk sharing between the younger and the older beneficiaries. In recent years, employers have typically veered more towards contribution plans in an attempt to lower their risk of obligations, while employees prefer funds that are easily transferable between employers. According to estimates by Morgan Stanley, global pension funds hold assets worth roughly $20 trillion.
  • Sovereign Wealth Funds A sovereign fund consists of money derived from a country’s reserves, which is earmarked for investment. The money for a sovereign fund is obtained from the reserves of a country’s central bank that gets accumulated due to surpluses in budget as well as trade. The types of financial instruments that a sovereign wealth fund can invest in vary from country to country. Countries with strong reserves opt for a greater proportion of risk assets, while countries with liquidity concerns seek enhanced exposure to highly liquid government debt instruments. Norway’s Sovereign Oil Fund, with assets worth over $1 trillion, and a whopping 1.30% of stake in global equities, is the world’s biggest sovereign wealth fund.
  • Insurance Companies Like pension funds, insurance companies are also long-term investors. Though they have historically provided insurance against the risk of policy holder’s death, they are also being increasingly utilized as long-term savings vehicles. Earlier, liabilities of insurance companies were fixed, with guaranteed returns in the event of death of the policy holder. However, more and more companies are offering variable returns that may or may not be market-linked. Insurance companies also act as external managers of pension funds, or provide insurance to defined benefit funds at the behest of small-time employers.
  • Mutual Funds Mutual funds pool assets to invest. They strive to enhance the return profile of an individual investor by taking advantage of greater portfolio diversification and economies of scale, particularly as regards transaction and management costs. Investors in these funds bear all the risk. Mutual funds differ from other long-term institutional investors on account of their increased short-term liquidity, albeit at return rates that are conditional on current market prices. The short-term liquidity can be achieved either through direct redemption of an investor’ holdings, or via the flexibility to trade shares of the mutual fund on stock exchanges. According to figures from the Investment Company Institute, at the end of 2016, mutual funds worldwide held assets worth approximately $40.40 trillion.
  • Hedge Funds Hedge funds are akin to private, unadvertised, close-ended mutual funds that are open only to high net-worth individual investors or other financial institutions. Hedge funds undertake relatively higher risk to generate potentially higher returns. They can engage in short-term trading, initiate short positions, and also leverage their capital – options not available to most other institutions. Due to their greater risk appetite and leverage utilization, hedge fund buying and selling can create sharp market movements. Since hedge funds have greater investment flexibility, they also have the scope to engage in more contrarian market activity. As of 2018, Ray Dalio’s Bridgewater Associates is the world’s largest hedge fund, with $150.00 billion in assets under management.
  • Endowment Funds Endowment funds are typically set-up by universities, hospitals, churches, scholarship funds and non-profit organisations. These investment funds are created for special purposes or to support an organisation’s operation expenses. Endowment funds are generally funded entirely by donations. The fund is managed either by a board of trustees or a team of professional asset managers, and is structured in such a way that the principal invested amount remains intact, with only the income generated from the investments available to the organization. As of January 2018, Harvard University had the largest endowment in the world with $34.50 billion in assets under management.

Common Characteristics of Institutional Investors

Risk-Return Trade off

  • A key element of institutional investors is that they provide a platform for small investors to pool together their assets, which in turn, creates a better risk-reward trade off in comparison to direct holdings. In general, institutions put a premium on diversification, holding a broad mix of both and international debt and equity. Institutional investors also seek liquidity and prefer liquid capital markets that offer standardized instruments, so that they can easily tinker their holdings in response to new market information.

Information Processing

  • Compared to individual investors, financial institutions are better equipped to absorb and process information. They employ specialized asset managers, who have a greater understanding of how the market operates, and can utilize techniques and strategies that are beyond the scope of retail investors. Moreover, in many cases, institutional investors have only long-term liabilities, enabling the asset managers to hold assets that may exhibit greater short-term volatility.

Economies of Scale

  • Given their size, institutional investors enjoy economies of scale, which results in lower average costs for the participating members. For example, the ability to buy-sell in large volumes provokes lower proportionate broking commissions. Furthermore, investors save in advisory fees by sharing the services of the expert investment managers with the other constituents. Size also enables institutions to transact in large indivisible assets, and establish countervailing power that can ensure fairer treatment from market intermediaries.

Importance of Institutional Investors

Financial Stability

  • In principle, a financial system that is filled with institutional investors should be more stable than a one that is bank-based. Under normal conditions, institutional investors, with better information and lower transactions charges, speed up the process of adjustment of asset prices to their inherent fundamental values. Moreover, the differences in sizes and types of institutional investors also act as a stabilising force in financial markets. The liquidity generated by institutional activity has the potential to dampen market volatility, as is evidenced by lower average stock price volatility in countries with greater institutional holdings. As regards the global context, greater overseas portfolio flows from institutions help in increasing market efficiency by equalizing the longer-term returns between the different regions.

Corporate Governance

  • Institutional investors act as important intermediaries between individual investors and business corporations. By pooling funds, institutional investors reduce the cost of capital for companies and entrepreneurs. From an individual investor standpoint, their greater ability to exert influence on corporate behaviour helps decrease costs arising out of conflicts between management and shareholders. Over the past couple of decades, there has been growing clamour that institutional investors play more active roles in the core decision-making process of companies they choose to invest in. These calls have only become louder amid the string of renowned corporate governance failures in the recent past.

Final Few Thoughts

The relative influence of institutional investors has steadily grown over time. This can be ascertained by examining their ownership of the top 50 publicly traded corporations in the United States. The average institutional holdings in these firms jumped from a mere 7% at the end of 1950 to roughly 67% at the end of 2010. This big yet gradual shift has come about as more people enter the markets through pooled-investment instruments.

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