Institutional Investors

Investing on behalf of Others

Most investors are ordinary people like you and I. Although we may not own shares or bonds ourselves, indirectly we own the majority that are available. That is because we own them through institutional investors.

Institutional investors act as highly specialised investors on behalf of others. For example, many people will have a pension from their employer. The employer gives that person's pension contributions to a pension fund. The fund will buy shares in a company or some other financial product. The pension fund is an institutional investor.

Institutional investors make financial markets possible, as they buy and sell the bulk of shares and bonds issued on our behalf .

Main points about Institutional Investors:

Institutional investors handle huge amounts of money.
They have a powerful influence in the City and provide companies with the capital they need to expand and compete in the market place.
Because they buy and sell so many shares, they play a large part in determining which listed companies will stay solvent, and which will go under.
Institutional investors have a lot of influence in the management of individual companies or corporations because, as shareholders, they are entitled to exercise voting rights in a company.
 There are three types of institutional investors, depending on the source of their funds: insurance, pensions and savings. All three handle the savings of individuals, directly or indirectly.
Insurance companies take regular payments of money from lots of people, in the form of premiums. These premiums create a pot of money which, when invested, creates the reserves that can be paid out to people if the insured event occurs (for example an accident, loss, critical illness or death).
Pension funds encompass two different types of pension schemes: defined benefit (final salary) schemes and defined contribution schemes. In both cases, there are certain types of more risky investment in which pension funds are not able to invest legally.
Defined benefit (or final salary) pensions are those in which a company and its employees contribute regularly to a pension fund. When an employee retires, they receive a proportion of their final salary until they die. Most of these schemes are no longer available to new investors. As life expectancy has increased, the pot just does not stretch far enough to pay out the full pension for so many people for so long.
Defined contribution pensions mean that, although employees and employers contribute in the same way as in a final salary scheme, the employee does not know how much income they will actually get from their pension. The amount will depend not only on how much they have contributed but also on how well the money has been invested.
Fund managers invest people's savings in securities (shares and bonds). Banks and insurance companies often have their own investment arms, but there are also many independent fund managers. They manage funds provided by lots of private individuals or by other institutional investors, such as insurance companies and pension funds.
Most fund management companies sell 'units' in the funds they manage - hence the funds are called 'unit trusts'. People buy these units, each of which represents a small fraction of the value of a fund. The money is invested as part of the total pot. When individuals wish to take their money back out of the scheme, they sell their units in return for the same fraction of the fund, whether it has gone up or down.
Institutional investors (other than fund managers) invest in a whole range of things: government bonds, corporate bonds, shares in leading companies, private equity funds, property, derivatives, currencies, commodities, cash and other things. They do this to minimise their risk - making sure they do not have all their eggs in one basket.
Fund managers administer funds which specialise in different kinds of investments. These have different levels of risk, and different points at which they bring income to savers.
One particular category of funds is labelled hedge funds. These specialise in high-risk investments, traditionally futures and forwards and options but now include a whole host of imaginatively named (and even more imaginatively conceived) investments.
Hedge funds have become very popular in recent years, and now account for a very high proportion of activity within the investment markets - on some days, half the total transactions are conducted by hedge funds.

Managing the Funds

The most complex of the institutional investors are the fund managers, who invest savings from individuals, pension and insurance companies. Some fund managers take higher risks than others; however high risk investments can also give big rewards.

For example, investment can be made in 'fledgling biotech companies in emerging markets', where all the elements involve a high degree of uncertainty. These could make massive gains if all goes well but, if things go badly, there will be massive losses. Alternatively, investment can be in the 'FTSE 100': the UK's 100 biggest companies by share value. Although less risky, these can still be subject to substantial ups and downs, however the fluctuations are likely to be smaller.

Lower risk investments include bond funds, as bonds give fixed returns.

Income funds buy the shares of companies which do not necessarily have mouth-watering growth prospects, but which produce a solid profit year-on-year and pay out handsome annual dividends to shareholders.

Growth funds seek out shares which will grow in value over the medium or long-term. These shares are normally in companies which (it is hoped) will grow much larger over a period of time, but which will do so partly by re-investing their profits rather than paying out dividends to shareholders.

Small-cap/mid-cap funds concentrate on smaller companies. These may have greater growth prospects than larger companies, but they stand a much greater chance of going bust. These investments are therefore riskier, but can see dramatic rises in value.

Index-linked funds are not managed on a daily basis (by managers continually switching investments in companies). Instead, shares are put into all the companies in a certain 'index' (such as the FTSE 100 index), so that the value of the fund goes up and down in line with the value of the index (which itself is basically the average of the value of all the companies it includes).

Sector or regional-specific funds focus on shares in a particular sector of industry, such as technology, telecoms, mining etc., or on a particular country or region such as Japan or the Middle East.

Hedge funds tend to use riskier investment strategies than other fund managers. For example, 'going short' is a common activity: selling assets which one doesn't own (but on which one has an option to buy), in the hope of buying them more cheaply later. This strategy, and others like it, make it harder for hedge funds to pay out to those leaving the funds; investors tend to be locked into funds for five years or so, ensuring that fund managers know how much money they have to play with over a given time frame. Hedge funds are less regulated than unit trust funds and are not open to private investors.

Hedge fund managers tend to borrow heavily - sometimes three or four times their capital. This means that when things go wrong for hedge funds, they can go wrong for a lot of banks as well. However, when things go right for these funds, they can make spectacular profits. Because of this and the somewhat unorthodox nature of their investment strategies, some successful hedge fund managers acquire almost cult status.