Institutional Investor: Meaning, Working, Types and Impact on Market

What is an Institutional Investor?

Key Highlights

• Institutional investors pool funds from several investors and people and make large capital investments in a variety of assets and securities.
• Firms like insurance firms, banks, mutual funds, pension funds, and hedge funds are examples of institutional investors.
• Institutional investors hugely affect the market because of the huge amount of trades they execute.
• Institutional investors frequently have specialised teams that research and trade in many markets, allowing them to use their knowledge and manage risks successfully.

Understanding Institutional Investors

Institutional investors come in a wide variety of characteristics. They invest in various types of assets. To achieve their distinct investment objectives, they are subject to various regulations. Interestingly, the legal definitions of institutional investors may also vary. Some could use the example of a company investing more than ₹100 crores in securities that are unrelated to it.

All types of institutional investors share a common characteristic. All of them are entities, not individuals. They consist of financial institutions, including banks, retirement plans, endowment funds, sovereign wealth funds, investment funds (such as mutual or hedge funds), and insurance firms.

What Qualifies as an Institutional Investor?

An institutional investor is defined by its size and the nature of its investment activities. These entities manage large sums of money and typically operate on behalf of other individuals or groups. Unlike retail investors, who invest their personal funds, institutional investors pool resources from various contributors to create substantial investment funds.

Characteristics of an institutional investor

• Scale and influence: Institutional investors manage large portfolios, which gives them significant influence over financial markets. Their investment decisions can impact stock prices, bond yields, and even broader economic policies.

• Professional management: These investors employ skilled professionals to manage their funds. These experts conduct thorough research and analysis to make informed investment decisions.

• Diversification: Institutional investors often maintain diversified portfolios to mitigate risk. By spreading investments across various asset classes and sectors, they aim to achieve stable returns.

Types of Institutional Investors

Now that you know what institutional investors are, let’s take a look at the different types of institutional investors.

1. Mutual Funds

It is the most popular one in the institutional investor category. Mutual funds pool the capital of several investors. This allows them to invest in a wide range of assets. For each mutual fund, qualified fund managers are appointed. As a result, people with little knowledge of the stock market may also invest their money. Additionally, the securities purchased through mutual funds often cover a range of sectors or asset classes.

2. Hedge Funds

Hedge funds are investing in partnerships. They pool money from the members to invest in different assets. The plethora of investors are referred to as limited partners. A general partner takes care of the fund management.

Its features are relatively similar to those of mutual funds. Both of them aim to lower risk and increase returns through a well-diversified portfolio. However, unlike MFs, Hedge funds follow more aggressive investing practices. So, they are considered to be risky as well. But the profits can be significantly higher.

3. Insurance Companies

Insurance firms have large holdings. These organisations invest the insurance premiums that policyholders pay. Since the total amount of premiums is large, their investments are huge. Insurance firms use the trading profits they make to cover claims.

4. Endowment Funds

Foundations usually set up endowment funds. The administrative or executive entity uses funds for its work. Usually, institutions like schools, colleges, hospitals, nonprofits, etc., create these funds. The managing organisation utilises the investment income from these funds to support its operations. The principal amount remains intact.

5. Pension Funds

Pension funds are a favoured subset of institutional investors. Investments from both employers and employees are permitted in pension funds. The cash raised are used to buy a range of securities.

Two different types of pension funds exist:

• Where in the pensioner receives a certain amount regardless of how well the fund performs.
• Where the performance of the fund determines the returns received by the pensioner.

Apart from these five groups, commercial banks are also considered institutional investors.

How Do Institutional Investors Work?

An Institutional investor operates by accumulating a sizable fund to invest. It invests on its own or for others. For instance, a pension fund may contain a huge amount of contributions from participants of a retirement scheme. Thus, the pension fund can work with an asset manager who offers specialised institutional services. It would not open an online brokerage account like a retail investor might do. An institutional investor may also make investments using its own funds. For instance, an insurance provider invests its clients’ premiums to generate a return to settle insurance claims.

Moreover, institutional investors frequently obtain unique, more advanced services from financial services companies due to their size. The institution could have access to extra services such as securities lending or research support.

How Do They Make Money?

Institutional investors generate profits through a combination of capital gains, dividends, and interest income. Capital gains arise from selling assets at a higher price than their purchase cost. Dividends are payments received from companies in which they own shares. Interest income is earned from bonds and other fixed-income securities. Additionally, institutional investors may engage in activities such as trading derivatives or lending securities to enhance their returns.

How do they Impact the Market?

Institutional investors are major players in the share market. This is because they trade in stocks and other financial instruments in far larger quantities than ordinary investors do. So they have a more prominent effect on asset prices.

For instance, if a major institutional investor sells 35,000 shares of Stock ABC, the supply and demand will instantly change. This will lower the stock's price. The price rises if the same investor purchases 40,000 shares of the same stock. This is because the supply falls short of demand. The price fluctuations can be very large when several institutional investors make such trades in a brief period of time.

Risks Involved in Institutional Investing

Despite their expertise and resources, institutional investors face several risks. Market risk is a primary concern, as fluctuations in asset prices can lead to significant losses. They must navigate liquidity risk, which arises when they cannot quickly sell assets without impacting their value. Regulatory risk is another challenge, as changes in laws and regulations can affect their investment strategies.

Key Differences Between Retail And Institutional Investors

Both retail and institutional investors want to maximise their returns on investments. Yet, there are several ways in which they differ. What distinguishes the two categories of investors is best illustrated by the characteristics listed below:

Ownership of the invested capital: Individual investors put their own money into the market, whereas institutional investors use the money of shareholders or businesses. Institutional investors trade frequently, but retail investors don’t.

Volume of transactions: Institutional investors transact huge sums of money. In contrast, the retail investors make relatively small investments using their savings.

Fees: Since they trade on a regular basis, institutional investors pay less transaction fees per trade. Whereas retail traders pay greater fees per trade.

Access to information: Individual investors conduct their research utilising data that is open to all investors. Institutional investors are experts on their own or collaborate with experts who undertake in-depth analysis utilising data that is only accessible to qualified investors.

Here are the differences at a glance

Benefits and Limitations of Institutional Investors

Institutional investors offer several benefits. Some are listed below.

Access to better resources: They have access to superior research, technology, and expertise, enabling them to make informed investment decisions. Economies of scale: Their large-scale operations allow for cost efficiencies, reducing transaction costs and management fees.

Market stability: By investing substantial sums, institutional investors can provide liquidity and stability to financial markets. However, there are limitations to consider. Below are some.

Concentration risk: Their significant influence can lead to market concentration, where a few large players dominate the market.

Systemic risk: The interconnectedness of institutional investors means that their failures can have widespread repercussions on the financial system.

Regulatory scrutiny: Due to their size and influence, institutional investors are subject to stringent regulations, which can limit their flexibility.

Conclusion

Institutional investors significantly dominate the securities market. As a result, market makers are a term that generally refers to institutional investors. They trade in high volumes as a result of the enormous number of investors participating. In comparison to retail investors, they tend to be more intelligent and are subject to fewer laws. Instead of investing their own money, the majority of institutional investors make investments on behalf of shareholders, clients, or consumers.