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
It can be any organization or company that pools funds from several sources – individual investors or other entities – and invests them in different market securities on their behalf. In other words, institutional investors are those market players that collect others’ corpora to buy and sell securities, like stocks, bonds, forex, foreign contracts, etc.
They usually trade in large blocks of securities. Therefore, institutional investors carry significant weight in this domain and are often touted as the whales of stock markets. An institutional investor example would be mutual funds.
The market perceives this category of investors as more knowledgeable and well-conversant in the ways of financial markets. And the perception holds since they possess not only specialized knowledge but also analytical resources at their disposal that a regular investor is not privy to. Due to that reason, institutional investors are also subject to less protective regulations.
Types of Institutional Investors
As mentioned earlier, 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.
Apart from these five types, commercial banks are also considered as institutional investors.
Impact of Institutional Investors
Institutional investors, by their very nature, carry significant clout in financial markets. They move hefty positions, both short and long, which constitute a large portion of the transactions in exchanges.
Thus, their dealings have a notable influence over the supply and demand dynamic of securities. Naturally, it follows that they have an impact on the prices of different securities as well.
Because of their eminence, several individuals also try to emulate the activities of an institutional investor in hopes of mimicking their success; however, this is not advised by investment experts.
Difference Between Institutional Investors and Individual Investors
The following table illustrates the differences between these two categories of investors.
Parameters | Institutional investor | Retail investor |
Definition | It’s any organization or person dealing in securities in large volumes on behalf of other entities. | It’s an individual who deals in securities via brokerage firms or other facilitators. |
Scope | Institutional investors can deal in securities and markets of all kinds. | Specific markets like forward markets and swaps are not particularly accessible by retail investors. |
Influence | This category of investors can impact the demand and supply of securities. | Retail investors do not individually possess the kind of influence to direct price movements. |
Merits of Institutional Investors
- They are significant sources of capital for publicly traded organizations.
- Institutional investors provide individuals means to mobilize their capital.
- They are privy to specialized market knowledge and various analytical resources, which allow them to improve the returns and reduce risks for their members.
Demerit of Institutional Investors
They hold considerable stakes in publicly-traded companies. If they decide to change their position, it can lead companies to potentially go bankrupt.
