Institutions have large sums of money, so it isn't surprising why companies and the market welcome them with open arms. These entities are (but aren't limited to) mutual funds, pension funds, hedge funds, and private equity firms. Their interests are generally in line with those of smaller shareholders. But institutional involvement isn't always a good thing—especially when the institutions are selling.
As part of the research process, individual investors should peruse sources like SEC Form 13-D, which is available at the Security and Exchange Commission's (SEC), and other sources, to see the size of institutional holdings in a firm, recent purchases, and sales. Read on for some of the pros and cons that go along with institutional ownership and of whichretail investors should be aware.
Key Takeaways
- Institutional investors are organizations that control a lot of money and buy large volumes of securities, such as mutual funds, pension funds, or insurance companies.
- These financial institutions own shares on behalf of their clients and are generally believed to be a major force behind supply and demand in the market.
- Whether large degrees of institutional ownership in a stock are positive or negative remains a matter of debate.
Smart Money of Institutional Ownership
One of the primary benefits of the institutional ownership of securities is their involvement is seen as being smart money. Portfolio managers often have teams of analysts at their disposal, as well as access to a host of corporate and market data most retail investors could only dream of. They use these resources to perform an in-depth analysis of opportunities.
Does this guarantee that they'll make money in the stock? Certainly not, but it does greatly enhance the probability that they will book a profit. It alsoputs them into a potentially moreadvantageouspositionthan that of most individual investors.
Institutions and the Sell Side
After some institutions likemutual funds and hedge funds establish a position in a stock, their next move is to tout the company's merits to the sell side. Why? The answer is to drive interest in the stock and to boostshare pricevalue.
In fact, that's why you see top-notch portfolio managers and hedge fund managers touting stocks on television, radio, or at investment conferences. Sure, finance professionals like to educate people, but they also like to make money, and they can do that by marketing their positions, much like a retailer would advertise its merchandise.
Once an institutional investorestablishes a large position, its next motive is typically to find ways to drive up its value. In short, investors who get in at or near the beginning of the institutional investor's buying process stand to make a lot of money.
Vanguard is the largest manager with $5.02 trillion in institutional assets under management (AUM) as of Dec. 31, 2022. BlackRock and State Street follow with $4.83 trillion and $2.4 trillion, respectively.
Institutions as Citizen Shareholders
Institutional turnover in most stocks is quite low. That's because it takes a great deal of time and money to research a company and build a position in it. When funds accumulate large positions, they do their utmost to ensure thoseinvestments don't go awry. To that end, they'll often maintain a dialogue with the company's board of directorsand seek to acquire stocks that other firms might want to sell before they hit the open market.
While hedge funds typically get the lion's share of attention, when it comes to being considered activist, manymutual funds have also ramped up thepressure on boards of directors. For example, Olstein Financial generated a lot of press for peppering several companies, including Jo-Ann Stores, with ways to drive shareholder value, like suggesting thehiring ofa new chief executive officer (CEO).
The lesson that individual investors need to learn here is that there are instances when institutions and management teams can and do work together to enhance common shareholder value.
The Scrutiny of Institutional Ownership
Investors should understand that although mutual funds are supposed to focus their efforts on building their clients' assets over the long haul, individual portfolio managers are frequently evaluated on their performance on a quarterly basis. This is because of the growing trend to benchmark funds (and their returns) against those of major market indexes, such as the S&P 500.
This process of evaluation is quite fraught, asa portfolio manager with a bad quarter might feel pressured todump underperforming positions (and buy into companies that have trading momentum) in the hope of achieving parity with the major indexes in the following quarter. This can lead to increased trading costs, taxable situations, and the likelihood that the fund sells at least some of these stocks at an inopportune time.
Hedge funds are notorious for placing quarterly demands on their managers and traders. This is due to the fact that many of these managers get to keep 20% of the profits they generate. The pressure on these managers and the resulting fickleness can lead to extreme volatility in certain stocks. In fact, it can also hurt the individual investor who happens to be on the wrong side of a given trade.
Individual investors' trading volume in equities is roughly 25%. The remaining 75% is handled by institutional investors.
Pressures of Institutional Owner Selling
Institutional investors can own hundreds of thousands or even millions of shares. So when an institutiondecides to sell its holdings, the stock will often sell off, which impacts many individual shareholders. This happened when activist shareholder Carl Icahn announced that he wished to sell his position in Mylan Labs in 2005. The company's shares shed 5% of their value the next day.
Of course, it's hardly possible to assign the total volumeof a stock's declineto sales by institutional investors. The timing of sales and concurrent declines in correspondingshare prices should leave investors with the understanding that large institutional selling does not help a stock go up. Due to the access and expertise enjoyed by these institutions—remember, they all have analysts working for them—the sales are often a harbinger of things to come.
The big lesson here is that institutional selling can send a stock into a downdraft regardless of the underlying fundamentals of the company.
Proxy Fights Injure Individual Investors
As mentioned above, institutional activists typically purchase large quantities of shares and then use their equity ownership as leverage, allowing themto obtain a board seat and enforce their agendas. While there can be a boon for the common shareholder, the unfortunate fact is that many proxy fights are typically drawn-out processes that can be bad both for the underlying stockand for the individual shareholder invested in it.
Take, for example, what happened at The Topps Company in 2005. Two hedge funds, Pembridge Capital Management and Crescendo Partners, each with a position in the stock, tried to force a vote on a new slate of directors. The battle was eventually settled but the common stock lost value during the three months of back and forth between the parties.
Again, while the full blame for the declinein the share price can't be placed on this one incident, these events don't help share prices move up because they create bad press and typically force executives to focus on the battle instead of the company.
Investors should be aware that although a fund may get involved in a stock with the intention of ultimately doing something good, the road ahead can be difficult and the share price can, and often does, wane until the outcome becomes more certain.
What Is an Institutional Investor?
An institutional investor is a large-scale investor. It is usually a company or firm, such as a mutual fund company, hedge fund, pension fund, or insurance company. Investors that fall in this category tend to buy and sell very large blocks of securities. Any moves they make can influence stock prices and the market as a whole.
Who Are the Most Common Institutional Investors?
Institutional investors are very large investors that buy large volumes of securities, such as stocks and bonds. They frequently use the services of an Institutional Shareholder Service provider to make informed decisions when voting during annual shareholder meetings. Some of the most common types of institutional investors include banks, mutual fund companies, hedge funds, pension funds, real estate investment trusts (REITs), credit unions, and endowment funds.
What Are the Three Types of Investors?
Businesses typically have three distinct types of investors. The first is called a pre-investor. These are generally friends and family members who provide some initial capital for the business to get off the ground. Passive investors offer capital to a company but, as the name implies, take no active role in its operations. The third kind of investor is the active investor. They not only provide funding, but they also actively participate in decision-making, management, and other areas that affect the business.
The Bottom Line
Individual investors should not only know which firms have an ownership position in a given stock, but they should alsobe able to gauge the potential for other firms to acquire shares while understanding the reasons for which a current owner might liquidate its position. Institutional owners have the power to both create and destroy value for individual investors. As a result, it is important that investors keep tabs on and react to the moves the biggest players in a given stock are making.
