Definition of an Institutional Investor
An Institutional Investor refers to an organization or legal entity that trades in the market on behalf of its clients, including retail investors.
These entities, often referred to as the “elephants” of the stock market, wield significant influence over prices due to their substantial trading volumes daily.
Institutional Investor | Source: Investopedia
Role and Influence of Institutional Investors in the Market
Over the past decade, the role and presence of institutional investors have experienced a significant increase.
They now dominate more than 70% of the trading volume across various asset classes. While these investors typically trade with their client’s investment portfolios rather than their funds, they still profit from these transactions.
Institutional Investors’ Dominance
The emergence of quantitative and algorithmic trading has further emphasized the importance of institutional investors.
They manage multiple funds simultaneously and act as vehicles for pooled investments.
Equipped with specialized teams that closely monitor market indices and analyze market swings, institutional investors are well-prepared to make timely trades without being exposed to the same risks as retail investors.
Their expertise and experience in navigating financial instruments give them an edge, and they also benefit from valuable consensus estimates provided by sell-side analysts, enabling informed decision-making that enhances the long-term value of their portfolios.
Influential Catalysts
Due to their large trading volumes, institutional investors have the ability to impact the price discovery mechanism and contribute to market growth.
The pooled investments they introduce play a pivotal role in the market.
Furthermore, as legal entities, they are generally more compliant with regulations and less prone to risk.
They employ strategies such as timely utilization of stop-loss orders to minimize losses.
Types of Institutional Investors
There are various types of institutional investors, with the six main categories being:
- Insurance Companies: These invest pooled premiums from clients in exchange for coverage, with claims compensated directly from the investment portfolio.
- Mutual Funds: These investment vehicles involve a professional manager overseeing an investment pool, with each contributing investor having varying ownership percentages. Mutual funds typically deal with liquid assets on a long-term basis and are often favored by novice investors.
- Hedge Funds: These investment funds employ aggressive strategies and leverage to outperform competitors. Hedge fund managers act as general partners, while investors serve as limited partners. Liquid assets are commonly traded in hedge funds.
- Banks: Commercial and central banks invest on behalf of their clients, engaging in various investment vehicles such as bonds and private equity funds.
- Credit Unions: These financial organizations offer shares that their members can purchase at predetermined rates. Profits are distributed among the members who are also the organization’s owners.
- Pension Funds: These funds consist of contributions from private and public sponsors and provide coverage for the post-retirement period of selected beneficiaries.
Differences Between Institutional Investors and Retail Investors
While retail investors are free to invest in any portfolio they choose, individual investors, particularly small-cap investors, may focus on short-term investments for quick gains.
On the other hand, institutional investors are more goal-oriented and prefer long-term investments with larger capital.
Diverse Investment Priorities
Retail investors tend to prioritize safety and may be deterred by market volatility, whereas institutional investors seek to leverage market swings to maximize their gains.
Institutional investors rely on the expertise of sell-side analysts and other professionals to navigate the market.
Amplified Market Leverage
Institutional investors have the advantage of engaging in larger market activities compared to retail investors.
They can acquire and manage multiple assets, benefiting from preferential treatment and looser regulations.
Additionally, institutional investors have greater access to foreign securities and other advantages not readily available to retail investors.