When it comes to the financial news, the phrase “institutional investors” is used frequently to describe an important cross-section of the market. But what does it mean, exactly?
An institutional investor is a non-bank person, entity or organization that buys and sells securities on behalf of its members. These market players typically invest in large enough quantities to qualify for preferential treatment, such as lower commissions and faster execution speed. An institution brings the benefits of participation to investors who previously lacked the resources to access larger financial markets. For this reason, institutional investors play a critical role in how markets behave and how assets are priced.
In fact, institutional investors have played a major role in the growth and widespread adoption of exchange-traded funds (ETFs). A recent study conducted by Greenwich Associates showed that institutional uptake in ETFs is expected to grow in the coming years as fund managers look to generate alpha through asset allocation as opposed to stock picking.
The report mentions that “institutions are making greater use of ETFs in strategic portfolio functions. They are using ETFs to obtain investment exposures in ‘core’ portfolio allocations, and as building blocks in top-down strategies that create alpha through asset allocation, as opposed to security selection. They are also employing ETFs to guard portfolios against volatility—a task growing numbers of institutions are addressing with smart beta ETFs.”
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Who Regulates Institutional Investors?
As the biggest component of the so-called “smart money” cluster, institutional investors are largely regulated by the U.S. Securities and Exchange Commission (SEC). In practical terms, this means they must file Form 13F with the agency to report quarterly holdings and must also submit Form 13G if they own 5% or more of a company’s stock.
Institutional investors have many advantages when it comes to stock picking, asset allocation and strategic investing. That’s because they have vast resources at their disposal, including research teams, registered investment advisors and deep pockets. Retail traders accessing the financial markets through their bank or financial broker do not have these advantages. They also lack the specialized knowledge and specific industry focus prevalent at large institutions.
Against this backdrop, it’s easy to see the oversized influence institutional investors have on the markets. Institutions dominate the swaps and forward exchanges and have even played an instrumental role in emerging sectors like Bitcoin and cryptocurrency. The institutional investor is one of the few market participants that can direct large sums of capital into a particular fund, industry or region. It therefore pays to have an understanding of institutional capital flows.
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The Types of Institutional Investors
Most market observers recognize six types of institutional investors. A brief summary of each is provided below.
- Pensions: Pension funds are the largest institutional asset owners, with more than $36 trillion in assets under management as of 2016. Pension funds are further split along various lines, including national, corporate, public and union.
- Insurance Companies: Insurance companies are another institutional investor that invests the premiums paid by their customers to grow their profits. According to the latest available information published by OECD, insurance companies own more than $25 trillion in assets globally. They are generally broken down into health, life and property categories.
- Endowment Funds: Universities, charities and other non-profit institutes are also classified as institutional investors. These organizations are funded by contributions, grants and charitable donations in pursuit of a particular cause or purpose.
- Commercial Banks: Major financial institutions like JPMorgan Chase & Co., Bank of America and Wells Fargo also fall under the institutional investor category. These banks provide deposit, credit and investing services to their clients.
- Mutual Funds: A mutual fund is an open-ended investment company that pools money from individual investors into one fund controlled by a portfolio manager. Those investment vehicles are used to purchase a variety of securities ranging from stocks to bonds and up to currencies.
- Hedge Funds: Hedge funds are classified both as institutional investors and alternative investments that use pooled resources to generate above-market returns. Typically, above-market returns rely on riskier investment strategies. Hedge funds have a higher barrier to entry than mutual funds and ETFs and are only available to accredited investors.
Institutional investors, in all their forms, dominate the ETF market. In 2017 alone, this segment of the market increased its ownership of U.S. ETFs by $213 billion to a whopping $1.4 trillion.
As of 2018, institutional investors (including investment advisors) accounted for nearly 60% of the $5 trillion ETF market. Nearly two decades ago, the institutions held just 30% of the overall ETF market. Retail investors, on the other hand, have seen their share ownership fall from roughly 70% to just over 40% between 2000 and 2018.
Analysts believe the ETF market could top $12 trillion by 2023, which would give institutional investors a roughly $7.2 trillion stake, assuming current ownership rates.
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The Bottom Line
Institutional investors have a vital role to play in the financial markets. Their appetite for ETFs means this particular segment of the market will continue to grow and innovate as investors look for new sources of growth and stability in an increasingly volatile market.