The stock market is a complex system made up of a wide variety of companies, brokers, investors, and other players. Although the complexity of investment options is often discussed, the nature of investors and their role in the well-oiled machine that is the stock market is often overlooked.
Although there are several types of investors that participate in the stock market, they all fall into one of two categories: retail or institutional.
Understanding the difference between institutional investors and retail investors and how they move markets will aid in your investing activities. Here’s what you need to know:
What Are Retail Investors?
Retail investors, sometimes called individual investors, are generally average people. These investors are investing for themselves with their own money rather than investing other people’s money. Their goals are as varied as the people who have them, ranging from investing for their children’s education to achieving a higher level of wealth and financial stability.
The mechanic who invests $100 per week in order to build a better retirement and the teacher who contributes 5% of her paycheck to a 401(k) are retail investors.
In recent times, retail investing has changed in a big way. In the past, retail investors would have to work through a financial advisor or other investment professional to make their trades. Today, retail investors have the ability to log onto their favorite online trading platform or trading app (Robinhood, SoFi, Stash, etc.) to select their investments themselves.
Not only has this increased retail investor access to the stock market, but it has also largely reduced cost. After all, a large percentage of online brokers don’t charge commissions or fees associated with trading activities.
As a result of these relatively new technologies, there are more retail investors in the market now than ever before, doing their own research, executing their own trades, and changing the dynamic of the stock market as a whole.
Pro tip: You can earn a free share of stock (up to $200 value) when you open a new trading account from Robinhood. With Robinhood, you can customize your portfolio with stocks and ETFs, plus you can invest in fractional shares.
What Are Institutional Investors?
The term institutional investors represents a large group of investors that are sometimes called the Whales of Wall Street. These investors are known for buying large blocks of stock, often leading to fluctuations in the prices of the stocks they purchase.
The reason institutional investors buy such a large number of shares is that they manage investments for groups of investors, giving them vast purchasing power. Because of their role as money managers for groups of investors, institutional investors have a fiduciary responsibility to act in the best interest of those represented by their investments.
Due to their standing as professional investors, the general belief is that institutional investors are generally more savvy than your average person. In fact, these investors are often referred to as “smart money investors.”
There are many different types of institutional investors. These include:
1. Exchange-Traded Funds (ETFs)
As their name suggests, exchange-traded funds (ETFs) are funds that trade on stock exchanges such as the Nasdaq and New York Stock Exchange. These funds are bucket investments that invest their assets into a diversified portfolio of stocks and other financial instruments. There are a wide range of exchange-traded funds on the stock market today. Some focus on particular sections of the stock market while others track the overall market or various commodities.
Fund managers who run ETFs decide when and where to invest assets managed by the fund on behalf of the fund’s investors.
2. Index Funds
Index funds work just like exchange-traded funds. The primary difference is that these funds are designed to mirror an underlying stock market index. For example, an index fund that’s centered around the Dow Jones Industrial Average will own positions in every stock listed on the Dow.
With index funds, fund managers decide when it’s time to rebalance the fund’s investment portfolio in order to keep the fund’s holdings in line with the underlying index it tracks and to synchronize the rate of return of the index fund with the rate of return of the underlying index itself.
Moreover, when an underlying index changes its holdings — for example, when a company is added or removed from the index — index funds will follow suit. These moves by index funds often lead to dramatic declines in stocks that are delisted from the underlying index and vast gains in stocks that are uplisted to the underlying index.
If you decide to invest in index funds, look for funds with the lowest expense ratio. After all, lower fees ultimately equates to higher returns.
3. Mutual Funds
Like ETFs, mutual funds are financial vehicles made up of funds from a large pool of investors. The pooled assets collected through these investments are used to buy securities like stocks, bonds, and money market instruments.
Mutual funds aren’t necessarily designed to track an underlying index or specific sector of the stock market. Instead, these are actively managed funds. That means money managers act on behalf of the investors in the fund following an investment strategy that’s outlined in the prospectus of the fund.
For example, some mutual funds are geared toward value investing, others are geared toward growth investing, income investing, or a wide range of other investment strategies.
4. Hedge Funds
Hedge funds are financial vehicles made up of assets from a pool of investors. However, these are the most actively managed and leveraged funds. Like mutual funds, hedge funds aren’t necessarily interested in tracking a stock market index or specific sector of the stock market. Instead, these funds are focused on capital growth.
Hedge funds are often considered a more risky investment opportunity because they take part in derivatives, short selling, and leveraged investing, which all have the potential to expand your profits, but are also high-risk investments that have the potential to lead to significant losses.
Recently, hedge funds have been a hot topic of conversation. Through the use of leverage and derivatives trading, many argue that hedge funds have too much control in the market and are in many ways legally manipulating prices in the stock market.
For example, if a hedge fund wants to make money off a falling stock, they’re able to buy massive blocks of short positions, ultimately driving the value of that stock down. Moreover, if they want a stock to go up, they are able to purchase large blocks of stock, greatly reducing supply and sending shares for the top.
These activities led a group of retail investors using a subreddit by the name of WallStreetBets to begin strategically buying shares of stocks that were short targets on the lists of hedge funds. In doing so, these retail investors forced short squeezes, sending struggling stocks like GameStop and AMC Entertainment for gains in multiples and costing hedge funds that had shorted them billions of dollars.
5. Pension Funds
Pension funds are also bucket investments that are generally highly diversified. However, pension funds got their name because they are composed of money paid by employers and employees for a pension — a type of defined-benefit retirement plan that pays participants periodic payments.
Returns from pension funds are paid to all participants that have reached the eligibility requirements for payment — mainly retirees who have given a certain number of years of service. Moreover, the fund managers at the helm of pension funds are held to the prospectus of the fund rather than a goal of tracking an underlying index or sector of the stock market.
The largest pension funds represent pooled assets from employees of several large companies, as well as state and federal government retirement programs including Social Security and the military. These pension funds control a large amount of capital and any changes in their holdings can have a big impact on the market.
6. Endowment Funds
An endowment fund is a fund centered around the legal structure for managing, and in many cases, perpetuating a pool of assets. These funds manage financial assets, real estate investments, and other investment assets in accordance with the will of its founders and donors. Endowment funds are also used to fund annual college scholarships at many institutions.
Endowment funds are generally used to fund charitable operations, and the assets managed by the endowment fund are invested based on a fiduciary responsibility to the endowment’s founders, donors, and beneficiaries.
7. Private Equity Funds
Private equity funds are made up of private equity investors who are interested in investing in private companies, acquiring controlling stakes of publicly traded companies, or taking part in take-private transactions where the private equity firm will acquire a publicly traded company.
Although they rarely do, private equity funds are capable of manipulating market prices. These funds set their sights on a select few companies and deal in large blocks of shares. When they buy, they increase demand and reduce supply greatly over a short period of time, leading to gains in price. When they sell, they flood the market with shares of the stocks they’ve targeted, ultimately leading to declines in price.
When the large buys take place, it is often done in an attempt to show the company that they have the ability to take a large enough percentage of the company to sway votes, attempting to pressure the company to take private equity deals. Selling large blocks of shares can be used to reduce the price of a stock, leading to uncertainty in the investing community and pressure from investors to take deals that may be on the table.
8. Insurance Companies
Just about everyone is familiar with insurance companies. Have you ever wondered what happens with your premiums once they’re paid? Of course, these premiums are designed to cover the cost of potential future mishaps and hardships. But what happens to that money in the meantime?
In order to expand their profitability, insurance companies generally invest a large portion of their assets in the stock market. As such, they are known for buying large blocks of securities, earning them their positions as institutional investors.
9. Commercial Banks
Commercial banks are also institutional investors and some of the largest investors in the world. Not only do banks invest on behalf of their clients, they generally invest their own financial assets in an attempt to increase their profitability.
Institutional Investors Don’t Buy Small
While the retail investor will generally buy shares in blocks of 100 or fewer, institutional investors have much deeper pockets, generally buying shares in blocks of 10,000 or more.
The number of shares purchased by institutional investors often steers them away from penny stocks and other relatively small companies for two reasons:
- Securities Laws. Acquiring a high percentage of company ownership could violate securities laws. In fact, mutual funds, closed-end funds, and ETFs that are registered as diversified funds are restricted with regard to the percentage of a company’s voting securities it can legally own.
- Supply and Demand. Also, if institutional investors were to take part in buying and selling large blocks of small, thinly traded companies, it could create imbalances in supply and demand that would push share prices higher or lower, and could be viewed as stock market manipulation.
This is one of the reasons over-the-counter (OTC) companies strive to be listed on major United States exchanges like the NYSE and Nasdaq — being listed on a major exchange opens a company up to institutional investors. It’s also often the reason for reverse stock splits that artificially inflate the stock’s price.
Institutional Investors Are Often Responsible for Sudden Price Movements
Although institutional investors make it a point to avoid trading in companies with small market caps, their moves often tend to result in dramatic swings of value anyway, and for good reason.
Retail investors often follow institutional investors, looking into regulatory filings with the Securities and Exchange Commission (SEC) for clues as to where the “smart money” is being spent.
As a result, when institutional investors buy a stock, we tend to see large increases in liquidity, high trading volumes, and high valuations as demand for the stocks they buy into increases.
The same type of moves can happen when high-net-worth investors and accredited investors take interest in a stock. These investors also generally make larger trades than the average retail investor and are also considered to be smart money investors on Wall Street.
Of course, not all institutional investors are large institutions. Smaller institutional investors won’t have the ability to cause such large fluctuations in the stock market.
Why Retail Investors Follow the Moves Made by Institutional Investors
There’s a good reason retail investors like to follow the moves made by institutional investors. While retail investors invest in smaller amounts than institutional investors, they are well aware of the fact that managers at financial institutions spend their entire working lives focused on the stock market.
As a result, these investors have a better understanding of the stock market and what it takes to generate meaningful returns than the average retail investor.
Think about it; you know that Warren Buffett’s Berkshire Hathaway is managed by some of the smartest investors, investment managers, and investment advisors that have ever lived. The firm manages an investment account that’s valued at hundreds of billions of dollars.
Wouldn’t it be nice to have the Oracle of Omaha and his team on your side? Well you can!
Due to their standing as an institutional investor, Berkshire Hathaway must disclose its moves in the market with the Securities and Exchange Commission. Many believe that by following filings released by these institutional investors, it’s possible to mimic the results generated in their investment portfolios.
The key takeaway is that retail investors invest their own money while institutional investors invest on behalf of a pool of customers or constituents. Institutional investors are essentially investment companies that live, eat, and breathe the stock market.
As a result of their constant work in the market, these experts are often considered to be “smart money” investors, and savvy retail investors closely track their moves.
Nonetheless, it’s important never to blindly follow the advice or moves made by any expert, even institutional investors. Ultimately, the best investment you can make is a well researched, well thought out investment that’s in line with the criteria outlined by your investment strategy.
It is a good idea to form your own opinion of an investment, then see whether institutional investors are also involved. If there are no institutions involved in the stock you’re interested in, it’s a strong indication that the stock is a risky play, and you may want to reconsider before investing your own hard-earned money.