Understanding Passive Institutional Investors: Definition, Role, and Impact

The financial market is composed primarily of two types of investors: retail investors and institutional investors. Institutional investors are companies or organizations that manage and invest funds on behalf of others. These investors pool money from different entities and invest it to generate positive returns.

An institutional investor is a company or organisation that pools money from other entities and invests the pooled funds in different market securities on their behalf. Mutual funds, pension funds, and insurance companies are common examples of institutional investors. Institutional investors can pool funds from individuals as well as other entities.

Examples of Institutional Investors

The following examples can help you better understand what an institutional investor is:

1. Mutual Funds

Mutual funds are one of the most common types of institutional investors. Mutual fund schemes pool money from different investors and invest the sum in a diversified basket of securities. Retail investors with limited market understanding and knowledge generally prefer investing through mutual funds. The fund house appoints an expert fund manager to manage and invest the pooled funds. Fund managers allocate the investment according to the scheme's investment objective.

2. Hedge Funds

A hedge fund is an investment partnership where money is pooled from members to invest in securities with the objective of earning positive returns. The pooled sum is managed by the fund manager, who is called the general partner. The group of investors are known as limited partners. Hedge funds operate like mutual funds but generally follow a more aggressive investment strategy and tend to be riskier. Given the higher risks involved, hedge funds tend to produce above-average returns for investors.

3. Insurance Companies

Insurance companies are also institutional investors that invest the premiums collected from policyholders into various assets to generate returns. Since insurance companies collect premiums from a wide range of policyholders, the aggregated investment amount is quite substantial.

4. Endowment Funds

Endowment funds are generally created by foundations or entities like schools, universities, colleges, hospitals, and other charitable organisations. Such funds are created with the objective of principal protection.

5. Pension Funds

Pension funds are another common type of institutional investor. Both employers and employees can invest in pension funds. The pooled funds are utilised to purchase various market securities and earn returns.

According to the meaning of institutional investors, these investors pool money from their members and clients to invest on their behalf. Institutional investors use different strategies to invest. They generally spread investments across various asset classes like stocks, bonds, forex, real estate, and gold to diversify, optimise returns, and minimise risks. Additionally, institutional investors make investments according to the interest of the actual investors. In other words, the asset allocation strategy matches the investors' interest. Their goal is to generate positive returns for investors.

Role and Impact of Institutional Investors

The chief role of an institutional investor is to buy, sell, and manage securities on behalf of its members, shareholders, or clients. Institutional investors are tasked with the responsibility to use their specialised knowledge and resources to find investment opportunities that may not be open to regular retail investors. By virtue of their enhanced market knowledge, institutional investors also face fewer regulations than regular investors.

Since institutional investors conduct a high percentage of transactions on major exchanges, they can greatly impact demand and supply for securities, which, in turn, impacts their prices. The pooling of funds from various entities allows institutional investors to have a substantial capital base. Institutional investors deploy expert investment professionals to manage the pooled funds to champion the client’s financial interests. Institutional investors tend to possess thorough market knowledge and resources that give them an edge over regular retail investors. Institutional investors buy and sell in bulk, allowing them to alter the demand and supply for any market security.

Institutional investors carry a significant market impact potential due to their sizable market clout. These investors trade more sizable positions, both short and long, making up for a large proportion of the transactions happening on an exchange. This means that their trades have a significant impact on the demand and supply of securities and invariably impact their prices as well. This is why institutional investors are often called market markers. Institutional investors own a high percentage of ownership stake in publicly traded companies.

Institutional vs. Individual Investors

The meaning of institutional investors becomes clearer when you understand the differences between institutional and individual investors.

An institutional investor is a company or organisation that pools and invests funds on behalf of other investors. An individual investor is a retail investor who invests and trades in securities through a brokerage firm. Institutional investors can invest and trade in all types of securities across different markets. Certain types of markets, like the swap and forward markets, are inaccessible to individual retail investors. Individual investors do not hold enough power to influence the price movements directly. Institutional investors generally buy and sell securities in block trades of 10,000 shares or more. Institutional investors manage large capital pools and invest on the behalf of their members and clients to maximise returns. These investors play a key role in price determination in the securities market, given the hefty positions they hold.

Passive Investors: A New Paradigm

Passive investors are the new power brokers of modern capital markets. An increasing number of investors are investing through exchange traded funds and indexed mutual funds, and, as a result, passive funds-particularly the so-called big three of Blackrock, Vanguard and State Street-own an increasing percentage of publicly-traded companies.

In our paper, Passive Investors, we provide the first comprehensive framework of passive investment. A number of commentators have expressed concern, even alarm, over the growth of passive investors. The literature to date, however, ignores the institutional structure of passive funds and the market context in which they operate. Prior criticism has focused on two key attributes of passive funds.

First, passive funds, by virtue of their investment strategy, are locked into the portfolio companies they hold. In particular, they cannot follow the Wall Street rule and exit from underperforming companies the way traditional shareholders, particularly active funds, can. Second, passive funds compete against other passive funds primarily on cost.

We challenge this portrayal of the passive investor business model as incomplete and offer a more nuanced approach. Our key insight is that although index funds are locked into their investments, the shareholders who invest in these funds are not. Like all mutual fund shareholders, investors in index funds can exit at any time by selling their shares and, when they do so, they receive the net asset value of their ownership interest. Moreover, because mutual fund inflows are driven by performance, passive investors risk losing assets if their returns lag those of actively-managed funds on a cost-adjusted basis.

Incentives and Behavior of Passive Investors

Understanding the business model of passive investors leads us to develop a comprehensive theory of their incentives and behavior. We show that active and passive funds compete for investors differently. Active funds compete based on their ability to generate alpha through the use of their investment discretion-choosing particular securities to under- and over-weight relative to their benchmark on the basis of firm-specific information. If active managers can generate substantial alpha on a cost-adjusted basis, fund investors will exit index funds in favor of actively-managed alternatives.

Passive investors therefore seek to reduce the comparative advantage of active funds, i.e., their ability to exploit mispricing to generate alpha. Passive investors must do this by relying on voice, rather than exit. Importantly, because passive investors hold the market, their monitoring need not be and, as a practical matter, cannot be, firm-specific.

Practical Implications and Corporate Law

Our theory finds support in practice. We document the emerging engagement by passive funds and their increasing influence with respect to individual and market wide firm governance. We show that passive investors have responded to the incentives to identify governance weaknesses that contribute to underperformance and mis-pricing and to seek to reduce governance risk. We also document how passive investors are coordinating with and mediating the efforts of shareholder activists.

Our theory has important implications for corporate law. Although, we show that recent proposals to disenfranchise passive investors due to governance concerns appear to be misguided, we note that the rise of passive investors raises other potential concerns. These concerns, which have thus far been overlooked, include new types of conflicts of interest, access to information and the concentration of economic power in the hands of a small number of fund sponsors and advisers.

While the role of passive investors continues to develop, and it is too early to determine the impact of passive investors on economic outcomes, our Article provides a theoretical framework for analyzing passive investor behavior and documents how current passive investor engagement is consistent with that framework.

Images gallery