Look up the major shareholders of any Fortune 500 company, and chances are you’ll find a list of asset management firms, pension funds and investment companies.
Given the massive amount of capital under their control – often in the billions of dollars – these so-called institutional investors are the driving force behind much of the trading on Wall Street. And given the size of their purchases, they can also sway how companies operate.
Who Qualifies as an Institutional Investor?
An institutional investor is an organization that manages assets on others' behalf. In addition to public and private pension funds, they include insurance companies, private foundations and endowments. Often, these entities will hire an outside asset management company that invests money for them in accordance with the clients’ goals and objectives.
Because of their sheer size, these super-investors are a huge force in the capital markets. As a whole, institutions control more than $35 trillion in U.S. assets and own roughly half of all American stocks as of early 2014.
The following chart shows the various classes of institutional investors, ranked by the amount of assets they control.
Source: Rockefeller Foundation, Investment Company Institute
Not surprisingly, institutional investors place trades that dwarf the size of even a wealthy individual investor. That means that purchases or sales can have a significant impact on a security's value.
Pricing isn’t the only source of their influence. Given the number of shares they hold, institutional investors represent a key voting bloc for important company decisions. As such, an asset management firm or pension fund is more likely to have access to senior management than all but the wealthiest individual investors.
One of the common characteristics of these institutions is a portfolio-based approach to investing, which aims to achieve targeted returns while minimizing risk. Often, they’ll own a combination of stocks, bonds, money market funds, real estate and other assets to realize their objectives.
However, different types of institutional investors can have important differences. Among them is the time horizon under which they operate. Pension funds, for example, have the advantage of being able to predict their future liabilities with relative precision. After all, actuarial charts can help pinpoint how many people will retire in a given year and, on average, how long they’ll live.
By contrast, the cash flow of some insurance carriers is much harder to forecast. A commercial property insurer may go through a couple years of historically low payouts, only to face claims from a massive hurricane. In these cases, the liquidity of assets becomes a greater concern, creating a bias toward short-term investment opportunities.
In addition, regulations vary considerably from one industry to another. Pension funds, for instance, are subject to the Employee Retirement Income Security Act of 1974 (ERISA), a law aimed at protecting American retirees. ERISA requires, among other things, minimum standards for plan participation, vesting and benefit accrual. It also classifies pension asset managers as “fiduciaries” who bear the legal responsibility of acting prudently and in the best interests of beneficiaries.
A Sophisticated Approach
Given the amount of assets in their control, institutional investors have a huge incentive to place the right trades at just the right time. Typically, their asset management firm will have in-house analysts whose job is to follow a stable of companies and determine whether the current price of securities justifies a purchase or sale. They may also use research from outside companies to aid in the decision-making process.
In addition to professional research teams, large investors have other significant advantages over a typical shareholder. Because of the size of their trades, they often receive discounted fees and commissions that appreciably increase their profit potential.
Institutions can also pursue certain opportunities that simply aren’t available to most retail investors, such as private placements. A private placement occurs when a company sells securities but wants to avoid the cost and extensive disclosure requirements of a public offering. For accredited investors, including pensions and insurance companies, these sales represent a way to diversify their holdings and pursue stocks that aren’t available to the broader market.
Given the unparalleled expertise and research available to institutional investors, perhaps it’s only natural that some individuals try to boost their portfolio by following their lead. These copycat, or coattail, investors duplicate the big firms' transactions shortly after they’re executed.
This may seem like an enticing strategy, but there are clear risks. For one, asset managers may have different goals than the individual investor. They may be looking for high-risk, high-reward opportunities, whereas the retail investor treading behind them needs safer, long-term growth.
Copycat investors should also be aware that the pricing they receive won’t always be as favorable as institutions enjoy. Consider a mutual fund that buys 3% of a company’s outstanding stock for $50 a share. The very size of this transaction may push the price up to $50.50, which is the amount retail investors now have to pay.
Say the fund sells its shares when they reach $52, generating a gross profit of $2 per share. Again, the transaction's magnitude influences the market value, so it now trades for $51.50. In this case, the coattail investor garners a profit of $1 a share, but it’s half of what the investment company pocketed.
The Bottom Line
Institutional investors have a massive impact on the capital markets, owning about half of all U.S. stocks. While the objectives and regulations under which they operate may vary, institutions are largely alike in bringing a high level of sophistication to investing.