Have you ever wondered who facilitates the movement of stock prices? What about those who adjust the prices of other financial products? If you have, we have the answer for you: institutional investors.
Financial markets are made up of many small players, known as retail investors, and a handful of big players, called institutional investors. Both of them come together to form the markets we see today. In this article, we’re going to discuss what an institutional investor is, the part they play in guiding the markets, and how they differ from other types of investors.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not investment advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions.
What is an Institutional Investor?
An institutional investor is an entity that gathers together money from individual investors to invest on their behalf. Their goal is to earn profits for their clients (and themselves in the process, of course).
There are many different types of institutional investors playing the field today. Some gather their money from retirement accounts, such as a 401k or Roth IRA, while others collect money from anyone who wants to invest (such as mutual funds).
Regardless of where the funds come from, they all aim to secure the best return possible for their clients. They do this by investing in blocks of stock, bonds, mutual funds and ETFs, REITs, and various other investment vehicles.
Some various types of institutional investors you may or may not have heard of include:
- Hedge Funds
- Pension Funds
- Mutual Funds
- Insurance Companies
- Investment Banks
- Credit Unions
Retail Investors vs Institutional Investors
While institutional investors certainly buy and sell a majority of financial products in the market, they aren’t the only player. Retail investors also throw their money into the market (though admittedly in much smaller amounts).
Retail investors can be defined as anyone who buys and sells stocks, bonds, or other financial products for themselves. Typically, they do this through a broker, bank, real estate agent, trading app, etc. Retail investors aren’t investing for others; they are simply managing their own money.
Many people choose to invest their money through institutions because it removes the burden of trying to keep up with the market. Furthermore, institutions have the ability to take advantage of investments that retail investors can’t acquire on their own. For instance, they have access to any asset class, financial product, investment strategy, and geographical market.
Furthermore, as a retail investor, it can be hard to manage your risk because you likely have substantially less capital. Institutional investors, on the other hand, have the luxury inherent with large numbers. Instead of investing in a handful of stocks, for example, they can invest in a myriad of different stocks. This offsets the losses of a few stocks by spreading risk amongst hundreds of investments.
As a retail investor, on the other hand, if one of your investments performs badly, that may account for a substantial amount of your total capital. Institutional investors can diversify on a scale that retail investors simply cannot. By doing this, they minimize their risk while maximizing their potential return.
How do Institutions Invest?
As you can imagine, institutions buy and sell huge quantities of various financial products at one time. This may make you wonder: who do they buy them from and sell them to?
The answer is Wall Street, or more specifically, investment banks. Investment banks serve as a market maker for these institutional investors.
For example, let’s say Hedge Fund A wants to sell 1,000,000 shares of Apple Stock because they think the stock is overvalued. It would be very difficult for them to find an individual that would be willing to buy all those shares.
This is where Wall Street steps in. Investment banks are always willing to buy or sell a security, no matter how over- or undervalued it appears. In our example, Hedge Fund A calls an investment bank and tells them they want to sell their Apple shares. The investment bank then tells them at what price they are willing to buy the shares. Once they come to an agreement, the deal is made.
Investment banks provide this service not just for stocks, but every type of financial product. The range spans from high-yield bonds to interest rate sweeps, and everything in between.
If investment banks didn’t provide this service, then it would be very difficult for institutions to trade at the speed and scale that they do. Financial markets change quickly, and banks allow these institutional investors to take large positions very rapidly to capitalize on the upward movement of a product. They also allow institutional investors to move out of positions to mitigate their losses if an investment is performing badly.
Institutions as Market Movers
The scale at which institutions trade is massive.
When Hedge Fund A decides it wants to sell a large position, this can significantly affect the market price of that particular security. When they decide they want to sell 1,000,000 shares of Apple stock, there is now an abundance of Apple stock in the market. This trade can shift supply and demand for Apple stock and push its price lower.
If more people want to sell Apple stock than want to buy it, investment banks will lower the price at which they are willing to buy the stock. While investment banks aim to provide liquidity to the market, they are also trying to generate a profit for themselves as they buy and sell.
On the flip side, if Hedge Fund A is looking to double down on their position and buy 1,000,000 shares of Apple, the investment bank will do their best to source that order. As they start buying up shares of Apple, the price will likely increase due to the new apparent demand for Apple stock.
As a retail investor, buying 200 shares of Apple has a negligible effect on the price of the stock because it’s not enough to affect the supply and demand balance. There are a finite number of shares for any given company. This means that when an institutional investor places a big order, it has a proportional effect on that stock’s price.
This is how the moves of institutions affect the entire market. While this may seem unfair to the layperson, institutions are necessary to keep financial markets running. They not only own a majority of financial products available, but they facilitate their price movements so that retail investors have a market in which to invest.
What Can Institutional Investors Buy that I Can’t?
There are certain types of investments that as a retail investor, you just don’t have access to. The only way you can access these investments is by handing your money over to an institution to buy it on your behalf. Examples of these financial products include:
- Collateralized Loan Obligations (CLOs)
- Credit Default Swaps
- Leveraged Loans
These are just a few examples of capital-intensive investments that an average retail investor does not have access to. There are funds that have a sole focus on a certain product, but as a retail investor, you would still have to go through that institutional investor to gain exposure.
Goals of Institutional Investors
Institutional investors are solely focused on making returns for their clients. Whether they’re a mutual fund comprised of everyday people’s life savings or a hedge fund for high net worth individual, the goal is always the same: maximize returns at minimal risk.
Various institutions have different ways of going about this. There are some funds that focus on a specific product or market, while others aim for steady growth over time. Some institutional investors are willing to take on a substantial amount of risk because their clients are willing to take on a substantial amount of risk. Other growth-centric funds are more risk-averse.
At the end of the day, it is the job of the Institution to align their investment strategy with the goals of their clients.
As an investor looking to park your money somewhere other than a bank account to try and get a return, you have lots of different options. While these institutions have a big effect on the market, their assets under management is made up of money from people like you and me. You can shop around these various institutions looking for the one that best fits your needs, capital, and risk level. No matter your investment goals, there is a fund out there suited to your needs.
A Final Word
Institutional Investors are made up of everyday individuals, but their reach far exceeds that of the layperson. They invest on behalf of others to remove the burden of investing for yourself. Furthermore, they are good at what they do and exert a significant amount of influence over financial markets.
While it may seem like they have a disproportionate amount of control over the markets, they also help the gears keep turning and markets stay moving. Anyone can become an investor whether they do it themselves or have an institution do it for them.
Institutional investors are the cornerstone of the modern financial market – and now you know how they work!