Institutional Investor: Working, Types, Characteristics and Example (2024)

Who is an Institutional Investor?

An institutional investor refers to a company or an organisation that invests money on behalf of other people. Institutional Investor engages in transactions related to stocks, bonds, and other securities on behalf of others, including members, subscribers, shareholders, etc. They pool funds from multiple sources, including investors and other entities, and invest those funds in different securities in the market on their behalf.

For example, institutional investors include mutual funds, banking institutions, hedge funds, insurance companies, venture capital funds, and pension providers. These are the investors involved in buying and selling substantial stocks, securities, forex, bonds, etc. They are also subject to fewer restrictive regulations as compared to retail investors.

How Does an Institutional Investor Work?

Institutional investors meaning refers to certain individuals or companies pooling funds on behalf of other investors. These investors include pension funds, mutual funds, endowment funds, commercial banks, hedge funds, and insurance companies. This means that these institutional investors could work for above-mentioned organisations and invest the money collected by them.

Example:

Take a mutual fund house for an example. A mutual fund house is an example of an institutional investor. When a mutual fund company launches a mutual fund scheme, they attract investors who invest their money in the scheme, which is managed by a fund manager.

The pool of collected money is then invested in a range of securities based on the asset allocation strategy chosen by the fund manager, and the investment principles of the mutual fund. The primary goal of such an institution is to generate high returns for investors.

Types of Institutional Investors

Listed below are the primary types of institutional investors:

1. Mutual Funds

These are considered one of the most popular institutional investors. Mutual funds help facilitate investment in various securities. Institutional investors pool the funds collected for a mutual fund scheme and invest it in a basket of securities. Retail investors who have a limited understanding of the market but want to start investing can rely on mutual fund houses to mobilise their funds. The primary objective of these institutions is to reduce risk and generate high returns via diversification in the investment portfolio.

2. Hedge Funds

These are defined as investment partnerships where institutions collect money from members and invest in securities. Furthermore, there is a fund manager, referred to as the general partner, and a group of investors, referred to as limited partners. Hedge funds are very similar to mutual funds since hedge funds are also designed to maximise returns and reduce risks. However, hedge funds are characterised by more aggressive investment policies and are private investment vehicle that is available only for accredited investors. Thus, hedge funds are comparatively riskier institutional investors.

3. Insurance Companies

As an institutional investor, an insurance company employs the premiums they have collected from the policyholders as the investment corpus. These institutions then invest the collected amount into various securities to generate maximum return. The investments are significant since insurance companies collect premiums from a number of policyholders. Eventually, the returns that the insurance companies receive on investing premiums are used to pay out insurance claims.

4. Endowment Funds

These are created by foundations, including hospitals, schools, universities, and charitable organisations, to be used for different purposes. The endowment funds are designed so that the principal amount remains intact and the returns are used to finance the organisation’s activities.

5. Pension Funds

Both employers and employees can invest in pension funds where the funds pooled are used to purchase various types of securities. Pension funds are of two types, one where the pensioner receives a fixed return regardless of the performance of the pension fund, and the second where the returns are based on the performance of the pension funds.

Impacts of Institutional Investors in the Financial Market

The influence of institutional investors on financial markets is significant. They affect prices, improve market efficiency, and shape corporate governance practices. They are also important in impact investing, where they promote positive social and environmental outcomes. Overall, institutional investors are major players in the financial markets, and their actions can have a significant impact on the economy.

Characteristics of Institutional Investors

The characteristics of institutional investors are listed below:

• An institutional investor is always a legal entity that represents or manages a fund; it is the organisation that is an institutional investor, not the person managing it.
• Institutional investors manage assets based on their client’s interests and goals, and they solely operate on a professional basis.
• There is always a large number of funds managed by a single institutional investor.
• Can influence stock prices by buying and selling large quantities of securities.
• Can boost market efficiency by conducting research and identifying market mispricings.
• Have a large voting stake in the companies in which they invest, allowing them to influence corporate governance practices.

Risks in Institutional Investing

1. Market Risk

Here the value of investments will decline as a result of changes in market conditions, such as economic downturns or changes in investor sentiment.

2. Credit Risk

This is the risk where borrowers will default on their debt obligations, resulting in losses for investors who hold those debts.

3. Inflation Risk

inflation will erode investment purchasing power, resulting in lower real returns.

4. Liquidity Risk

Investments cannot be sold or traded in a timely manner to meet the needs or demands of investors.

5. Political Risk

Changes in government policy or political instability will have an impact on the value of investments.

What Qualifies as an Institutional Investor?

An institutional investor is a large organisation that invests on behalf of someone else. These investors are typically pension funds, endowments, insurance companies, mutual funds, and hedge funds, as well as banks and other financial institutions. Institutional investors can allocate large sums of capital to a variety of asset classes, including stocks, bonds, and alternative investments.

How Do Institutional Investors Make Money?

Institutional investors make money by investing in a wide range of asset classes, including stocks, bonds, real estate, and alternative investments, in order to generate returns for themselves or their clients. These investors typically have a lot of money to invest and can diversify their portfolios to reduce risk and potentially increase returns. In addition, institutional investors frequently have access to specialised investment strategies, market insights, and research that can assist them in making informed decisions and identifying opportunities. They can make money in a variety of ways, including dividends, interest, capital gains, and client fees. The ultimate goal of institutional investors is to generate long-term returns that exceed the expectations and goals of their clients.

Differences Between Institutional Investors and Retail Investors

The following points highlight the differences between institutional and retail investors:

Benefits of Institutional Investors

Here are the primary benefits of institutional investors:

• Institutional investors are the primary source of capital funds for publicly traded companies.
• They know the ins and outs of the various security markets and have access to multiple analytical tools. It allows them to diversify investments, maximise returns, and reduce the likelihood of financial losses.
• Institutional investors act as a medium for individual investors to mobilise their funds.
• Can influence corporate governance practices, promoting responsible business practices and increasing transparency.

Limitations of Institutional Investors

Listed below are the primary drawbacks and risks associated with an institutional investor:

• Since they hold considerable influence over companies they have invested in, it can lead to financial instability in a company if they decide to pull their investment out. This is true for all other securities the institution has invested in pulling out investment from security can lead to instability in its price dynamics.
• There is a lack of clear and well-established policy concerning the payments of dividends.

Important Points to Know About Institutional Investors

Here are some important points about institutional investors you should know about:

• As compared to individual investors, institutional investors have access to and can leverage large amounts of money.
• They also directly determine a company’s ability to scale and remain profitable and competitive.
• Institutional investors follow specific guidelines while making investment decisions.
• Lastly, they look for investments that are highly predictable, stable and carry a low risk.

Final Word

Institutional investors constitute a significant portion of the securities market. Thus, institutional investors are often referred to as market makers. Owing to the number of investors involved, they trade in large volumes. They are generally more sophisticated and are subject to fewer regulations than retail investors. Most institutional investors invest on behalf of customers, shareholders, or clients, rather than investing their own money.

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Disclaimer

This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.