Potential pros of being a retail investor:
- Able to play the long game
As institutional investors and institutional clients expect results either yearly or quarterly, they tend to trade more frequently and sometimes even over-trade, resulting in higher fees that could lead to their investment underperforming. Retail investors may be better able to ignore short-term market corrections, revisions, and modifications and can stay vested for the long run if they feel that they have found a worthwhile investment. Put simply, they typically are able to have the patience that institutional investors and institutional clients sometimes do not.
- Smaller investments are easier to make
Retail investors have the freedom to invest in companies of any size and are able to invest in smaller companies. Larger institutional investors and institutional clients may be limited in the kinds of investments they can consider because they have such large amounts to invest. As a result, the bottom line is that retail investors are able to take advantage of the small firm effect.
- Able to hold cash
In the United States, retail investors can sell out of the market or sell stocks when the prices are high and wait for a better buying price, further improving their potential return on investment.
- Liquidity
As retail investors are only able to buy and sell shares at a small scale, stock prices, commodities, and growth stocks are generally unaffected by their buying or selling actions. The smaller quantity of stocks makes them more liquid for retail investors. Institutional investors are able to have a much greater impact on stock prices and the volume at which they trade can make it harder to buy and sell. Moreover, they also have a stronger effect on market sentiment and can cause panic selling.
- Diversification vs. focus
Diversification is not what it used to be but is often a mandatory requirement for institutional investors. Retail investors however are free to focus on whatever category of investments they want in their diversified portfolio as they are expected to manage risk themselves.
- Personal interest
As retail investors are individuals who are investing their own money, they are more likely to take a keen interest in monitoring and nurturing their investments. Institutional or professional investors and traders are doing so on behalf of another entity and so may not be able to pay as much individualized attention as you can to your own personal account or portfolio.
There are also applicable laws and general fiduciary duties that help to prevent conflicts of interest and provide investor protections, for example under the Exchange Act.
What is an institutional investor?
An institutional investor is an entity that makes investment decisions on behalf of individual members or shareholders. These investors typically trade 10,000 or more shares at a time and only engage in large transactions with large sums of money. The growth of the institutional investor is staggering. Recent stats show that 80% of the ownership on the S&P 500 is attributed to institutional investors. Additionally, as the overall volume of stocks rises, institutional investors increasingly own a higher percentage of large companies.
While complex investments in smaller companies are generally off limits to institutional investors, they have access to an investment benchmark that is not available to retail investors. For example, because of their huge pool of capital, institutions might invest in assets like commercial real estate, currencies, and futures.
As institutional investors have large resources and new technology at their disposal, they are able to put in a lot of research and financial analysis when reviewing investment options. There are six different types of institutional investors:
Pension funds
A pension fund is an investment pool that pays employees upon retirement. There are two types of pension plans:
Defined Benefit Fund
In this pension fund, an employee contributes, generally, a fixed amount of pre-tax income. Upon retirement, this fund pays a fixed amount to an employee, regardless of the performance of the fund. The individual contributes over time, and the amount paid out is determined by years of service and how much the employee has contributed. The individual contributor makes no decisions about the investments–those decisions are made by the money managers and portfolio managers at the institution based on available information.
Defined Contribution Fund
In this plan, the employee’s retirement benefit is dependent on how well the fund performs. The most common of these are the 401(K) and the 403(B). The contributions are made pre-tax and grow tax-deferred until withdrawal.
Mutual funds
A mutual fund is an investment vehicle made up of a portfolio of stocks, bonds, index funds, or other securities. Investors, including retail investors, can purchase shares of a mutual fund based on the price of the security. The investor makes money from the fund in three ways: from dividend payouts, from a capital gain resulting from the sale of a security, or from the sale of the actual mutual fund.
There are a number of different types of mutual funds, including stocks (equity), bonds (fixed-income), balanced, and money market funds. Mutual funds also have more government regulation than some other institutional investors such as hedge funds.
Hedge funds
Hedge funds use pools of capital from investors to invest. Hedge funds are generally not open to the retail investor as hedge fund investors are required to have at least $1 million in net worth. These funds invest in a number of ways, but one of the primary goals of the fund is to ‘hedge’ against losses in the overall stock market [Government’s investor bulletin]. To invest with a hedge fund, you need to be an accredited investor. But even after you’ve met one of the three criteria for being an accredited investor–your accreditation has been validated, you meet the financial statements threshold of $200K/year individual/$300K couple, or you have $1 million in assets–you might still be denied the investment in a hedge fund. In recent years, changes to the definition of accredited investor have been proposed and some were accepted in the last month. You can visit the SEC website to learn about SEC Chairman Jay Clayton’s take on these changes.
Banks
Commercial investment banks staffed by financial professionals and brokers, like JPMorgan Chase & Co., Wells Fargo, Citibank and Bank of America, are also considered institutional investors. These companies help facilitate access to capital markets and help corporations with financing.
Insurance companies
An insurance company invests the money that’s paid to it in the form of insurance premiums. Insurance companies tend to invest in more stable vehicles like bonds, but also invest in the stock market. A couple of years ago, the insurance industry had $4 trillion in cash and investment assets, making insurance companies a large part of the institutional investor landscape.
Endowment funds
These funds come from charitable donations, contributions, and grants, which are then invested. The capital is then put back into the university, charity, or other non-profit organization. As an example, in 2020 Harvard University had an endowment currently valued at $41.9 billion, and that’s just one of hundreds of school-based endowments in the country.
Advantages of being an institutional investor
- Fees
One of the main advantages that institutional investors have over retail investors is the fees paid for trades. As they are buying in bulk, big entities such as the ones we referenced above can negotiate better fees. Retail investors pay higher fees and sometimes are required to pay commissions and other related fees.
- Resources and buying in bulk
Institutional investors have the distinct advantage of being able to buy in bulk. Why? Simply put, the entity has more money at its disposal. With more money comes more buying power and the ability to buy a large number of shares at a time. An institutional investor’s account may also have less restrictions placed upon it.
- Access to securities
Large investment companies also have access to securities not available to other types of investors or small business prospective clients due to federal securities laws for financial products. An initial public offering (IPO) is a good example of this. With an IPO, there are two stock prices. The first, called the offering price, is offered only to select investors who meet certain criteria. When the stock begins trading, it trades at a different price, called the opening price, which is available to anyone who wants to buy it on the open market.
A level playing field for retail investors
The advent of FinTech platforms is helping to change the landscape for retail investors. Here are some of the upcoming changes that can be expected in the industry:
Better access to information
One big change is the access to information for the everyday investor. There is more financial information out there than ever before, more information on companies and performance, and more reliance on trading tools. Buying and selling stocks has become easier for the average individual, as information at your fingertips means that you have the opportunity to be a savvy investor by doing your homework and working with an analyst or financial advisor before you buy.
Lower fees
There are more options now for an individual investor to open investment accounts. Some brokers and investment advisers now have lower investment minimums than before, and there are even some ETFs and robo advisors out there that require zero minimum deposits.
Access to larger assets
Another significant change is that, slowly, retail investors are gaining more access to investments typically reserved for only large institutions. Companies like Yieldstreet are leveling the playing field, providing access to investments that were previously reserved for the super-wealthy. Yieldstreet is opening up the doors to alternative investment asset classes like real estate, marine finance, and art finance.
Institutional investors exert considerable influence on all asset classes. The difference between institutional and retail investors is large, but shrinking. While the two have their own advantages, the retail investor is slowly but surely becoming more knowledgeable about investments by gaining exposure to better information, reduced fees, and access to larger assets as new opportunities open up.
Summary
We have explored the main differences between retail and institutional investors, including their respective advantages and limitations. To sum it all up, retail investors are non-professional investors who typically invest in smaller amounts and trade less frequently than institutional investors. Retail investors may have the advantage of being able to play the long game, invest in smaller companies, hold cash, have more liquidity, focus on specific investments, and take a personal interest in their investments.
Institutional investors, on the other hand, have access to better fees, resources, and larger assets, and are able to conduct more research and financial analysis. Institutional investors, such as pension funds, mutual funds, hedge funds, banks, insurance companies, and endowment funds dominate the current investing world. But the retail investor landscape is changing due to the advent of FinTech platforms, which are providing better access to information, lower fees, and access to larger assets.
This is all to say that while institutional investors still hold considerable influence over all asset classes, retail investors are slowly gaining more knowledge and exposure to better investments, reduced fees, and access to larger assets. In the end, we’d say that both types of investors have their advantages, and it is important for investors to understand their own goals and risk tolerance in order to make informed investment decisions.
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