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.
The Basics
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
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
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.
Insurance Companies
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
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.
Foundations
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.
Amounts Traded
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.
Markets
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.
SEC Regulations
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.
Takeaways
- 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
In the finance world, investors are typically categorized into two groups: retail investors and institutional investors. Retail investors are individuals who buy and sell their own stocks, bonds, or other securities and manage their own portfolios. On the other hand, institutional investors are entities that invest money on behalf of others, such as companies, organizations, or enterprises. Institutional investors have a significant impact on financial markets and the companies they invest in due to their size and influence.
Types of Institutional Investors
There are various types of institutional investors, including:
- Hedge funds
- Private equity 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.
Role of Institutional Investors
Institutional investors are primarily engaged in asset management and investment management. They buy, sell, and manage stocks, bonds, ETFs, and other securities or investment vehicles, such as fixed-income investments. These investors allocate the assets they manage across different asset classes, with approximately 40% of assets allocated to equity, 40% to fixed income, and the remaining 20% invested in other alternatives like real estate, private equity, and hedge funds. However, these percentages can vary significantly among institutions [[6]].
Main Types of Institutional Investors
While there are many types of institutional investors, a few categories make up a significant portion of the institutional investing community:
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Pension Funds: Pension funds are the largest part of the institutional investing community, controlling trillions of dollars in assets. These funds are retirement plans in which employers make contributions to benefit employees in the future. The largest pension fund in the United States is the California Public Employees’ Retirement System (CalPERS) [[7]].
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Investment Companies: Investment companies provide professional services to banks and individuals looking to invest their funds. They can be closed-end funds or open-end funds, with closed-end funds offering a fixed number of shares and usually trading on an exchange, while open-end funds continuously issue new shares as they receive capital from investors.
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Insurance Companies: Insurance companies collect premiums from policyholders and invest those funds to generate profits and future claims. Life insurance companies typically invest in lower-risk securities like bonds, while property and casualty insurers tend to invest more heavily in equities.
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Savings Institutions: Savings institutions offer financial services such as deposits, loans, mortgages, checks, and debit cards. They control significant assets.
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Foundations: Foundations are typically created by wealthy philanthropists or companies and are dedicated to specific goals or purposes, such as improving access to education or healthcare. These institutions invest their assets to generate capital for their intended purposes.
Differences Between Institutional and Retail Investors
There are several key differences between institutional investors and retail investors:
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Resources and Knowledge: Institutional investors generally have more resources and specialized knowledge compared to retail investors. They often incorporate detailed financial analysis and ESG (environmental, social, and corporate governance) factors into their investment decisions. They may also have access to alternative investment opportunities and corporate insiders, providing additional intelligence [[13]].
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Amounts Traded: Retail investors typically trade in smaller amounts compared to institutional investors. Retail investors may execute trades through traditional or online brokerage firms and often invest in smaller companies' stocks due to lower price points. Institutional investors, on the other hand, trade in much larger volumes, buying or selling stocks in lots of 10,000 shares or more [[15]].
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Rules and Fees: Institutional investors are subject to fewer protective rules and are entitled to preferential treatment and lower fees. They are generally considered more market-savvy and qualified than retail investors. Institutional investors often meet personally with company executives, analyze entire industries and companies in depth, and make investment decisions based on comprehensive research [[17]].
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Impact and Influence: Institutional investors account for the majority of stock market activity, with estimates suggesting they contribute to at least 75% of daily trading volume in the United States. They have a significant influence on market supply and demand, affecting security prices and company valuations. Institutions own a substantial portion of the market capitalization of companies in major indices like the Russell 3000 and S&P 500 [[19]].
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SEC Regulations: Most institutional investors in the United States are subject to regulations by the Securities and Exchange Commission (SEC). They must report their quarterly earnings (form 13F) and disclose stock ownership if they own more than 5% of a company's issued stock (form 13G). These reports are public and provide insights into institutional investors' activities and portfolios [[21]].
Risks and Challenges for Institutional Investors
Institutional investors face certain risks and challenges due to their size and influence. These include stock volatility, inflation, general business risks, and the need to manage large quantities of information. Institutional investors also face increasing pressure to invest responsibly and consider social and environmental factors. Many have embraced ESG investing and integrate these factors into their research, security selection, and portfolio construction [[23]].
In conclusion, institutional investors play a significant role in financial markets, managing substantial assets and exerting influence on stock prices and company valuations. They have access to specialized resources, engage in extensive research, and often have preferential treatment and lower fees. However, they also face unique risks and challenges associated with their size and responsibilities.
