Institutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets. They can also include operating companies which decide to invest their profits to some degree in these types of asset (Wikipedia 2011)
According to Hanumantha Rao and Vijay Mishra (2007) financial markets are mainly classified as money markets and capital market. The term money market is used to denote the financial institutions which deal with the short term borrowing and lending money. Te term capital is used to mean the institutes which deal with the lending and borrowing of long term money.
Large companies such as banks, hedge funds, insurance companies, retirement and pension funds, mutual fund, labor union funds, finance companies, units trust and all other financial institutions which have huge and considerable funds to be invested are called institutional investors (Wikipedia, 2011 and Business Dictionary, n.d). For years, institutional investors are observed to contribute 50% to 70% of the market volume of any given day (Chenard, 2010). With their large funds and large share in the financial markets, institutional investors are assumed to be knowledgeable about financial markets and investment. Institutional investors are a force to reckon with as they are perceived to have so much power to wield and influence in the activities of financial markets. Thus the role and significant influence of institutional investors in the financial market domestic or global is indomitable.
The purpose of statements
The purposes of institutional investors are primary indicator of economic development in the financial market.
The importances of institutional investors for financial markets are due to the following reasons:
Institutional Investors Influence Corporate Governance to Increase Profitability. Institutional investors, with their enormous wealth and ownership of the majority of stocks of a firm can influence and wield power over corporate governance. There are passive institutional investors who do not interfere with the operation of the firm. This was the case before the 1990s. But there are also institutional investors who seek to influence control in the management of the company to improve profitability (Bofah, 2010). The latter is a phenomenon called shareholder activism. Activist institutional shareholders stirred financial markets of developing nations in the 1990s. In 1992 chief executive officers of very large firms such as IBM, General Motors, American Express Westinghouse and Compaq Computer were fired under the pressure of institutional investors. (Latest-Science articles, n.d.)
Institutional Investors Play as key factor in Reducing Information Asymmetries. In the financial market, information is of paramount importance. Institutional investors with their large capital usually seek and demand the right information from the firms selling shares of stocks. Firms on the other hand, and in reaction to the demands of the institutional investors that they want to attract to their company, provide organized and comprehensive financial information to the public, usually by employing information intermediaries to perform the specific role (Balling, Holm and Poulsen, n.d.). In this way, large, complex and incongruent information that are circulated in the financial world is reconciled, thereby reducing the flow of asymmetrical information and attracting more investors.
Institutional investors as financial intermediaries. Numerous institutional investors act as intermediaries between lenders and borrowers. As such, they have a critical importance in the functioning of the financial markets. Economies of scale imply that they increase returns on investments and diminish the cost of capital for entrepreneurs. Acting as savings pools, they also play a critical role in guaranteeing a sufficient diversification of the investors' portfolios. Their greater ability to monitor corporate behaviour as well to select investors' profiles implies that they help diminish agency costs.
Institutional investors dominate securities markets. About 75% of the UK Company's shares are held through institutional investments. Rise in Institutional investors have led to the emergence of an investment culture wherein investment has become part of the life style of many people. Print, TV and internet media has contributed a lot to build investment culture. According to International financial services, London World Wide Funds in pension, insurance and mutual funds reach $ 45.9 trillion by end of 2004.
One social implication of the growth in the relative importance of institutional investments is the disappearance of the distinction between workers and owners. In aggregate the workers own the companies for which they work. It is not the direct ownership of the specific companies for which they work. Each worker through rights in pension funds, life assurance policies and other institutional investments owns a slice of the aggregate of firms that have issued shares.
Many governments allow savings scheme that provide tax advantages for people. Much of this saving goes into institutional investments. One purpose of such schemes is to encourage people to save and make their own provision for retirement. Another purpose of encouraging financial investment is the provision of a flow of capital to businesses which seek to raise money by issuing shares or bond. (Keith Redhead 2008).
Institutional Investors are Critical Indicators of the Stock Market. In the stock market, institutional investor's buying and selling behavior is watched critically by individual stock traders, brokers and other institutional investors (Chenard, 2010). Their market behavior is used as an indicator of the health of the market, the firm and the stock price. With the institutional investors' wealth and knowledge, and their considerable amount of shares (50 to 70%) in the firm, their buying and selling behavior has a significant effect on the valuation of the stock. Stocks that are bought by them are considered good and profitable stocks and stocks that are sold are otherwise. The price of stocks that are desired and bought by institutional investors, rises and those that sold tumbles.
Having understood and recognized the benefit of institutional investors' confidence and investment in the firm, financial markets employ means to attract these large firms, even at some point pre-allocating stock market shares to institutional investors during Initial Public Offering (IPO). Institutional investors perform important functions that keep the financial market bullish or bearish. Institutional investors are important for financial markets because they influence stock market valuation reduce asymmetries in information; increase liquidity and influence corporate governance. (Huyghebaert and Van Hulle, 2004).
Institutional Investors affect the Firm's Liquidity. Institutional investors affect the firm's liquidity. Firms with considerable assets that can be easily converted into cash are likely to attract institutional investors in the same way that the ownership of institutional investors of a large amount of shares of a firm implies liquidity of the firm's assets. Investors' big or small are attracted to firms that have more liquidity because it is easier for them to buy and get out of the market quickly. (Wikipedia, 2013)
Institutional Investors and Private Equity. Institutional investors can have an importance in providing finance for young business beyond the provisions of collective investments such as venture capital trusts. The main institutional investors are pension funds, insurance companies, and mutual funds such as unit trusts, open-ended investment companies and investment trusts and hedge funds. Institutional investors may own private equity firms, which are firms that buy the shares of new or small businesses even though the shares are not-traded on a stock exchange. Money invested in such companies is often described as Private Equity.
Private equity firms became co-owner of the companies in which they invest and take an active managerial role in the companies with the expectations that the shares will eventually be sold to another private equity firm or to another firm that makes a take over bid or through the stock exchange when the shares are accepted for stock exchange listing.
Institutional investors particularly pension funds and insurance companies, are important provider of funds to private equity firms whether or not they own private equity firms. Private equity firms put together funds for their purchases and institutional investors are major suppliers of such funds. Even the funds are provided to purchase the existing enterprises by the managers of those enterprises (management buyouts).
Private equity is important to the economy as the companies financed by private equity can employ good number of people. In UK 18% of the Private sector workforce has been employed by private equity. The time scale of investment is typically 3 to 5 years. Private equity firms aim to buy businesses that have potential for development. Private equity firms aim to improve the businesses acquired and sell them at a profit (Keith Redhead 2008)
Influence of institutional investors on companies and analysts. The growing importance of institutional investors, in terms of their holding an increasing proportion of the total number of shares issued, has implications for corporate governance. Corporate governance concerns the way in which companies are controlled. Until the 1970s 'managerial capitalism' was dominant. A feature of managerial capitalism was that shareholding was fragmented. A company's shares were held by thousands of different shareholders. As a result shareholders could not easily coordinate to influence the management of companies. In consequence the managers of firms often operated them for their own benefit rather than for the benefit of shareholders. The concentration of shareholdings in the hands of a relatively small number of institutions has made it possible for those shareholders to exert influence over the management of companies. (Keith Redhead 2008)
Shareholders have voting rights at the annual general meetings, and those voting rights include
elections for the board of directors. Institutional shareholders can now force the managements to
give priority to 'shareholder value', in other words the interests of shareholders can now take
precedence over the interests of managers. In the last resort institutional investors can replace
directors. However that possibility may be enough to ensure compliance by managers. There are
other methods available, for example putting investors on the board of directors as non-executive
directors. Also share option schemes may be introduced in order to give the managers a personal
interest in the value of the shares. (Keith Redhead 2008)
Most individual shareholders do not own enough stock in a company to be able to influence its
management. Most individual shareholders do not believe that it is worth their time and effort to
try, particularly since they would bear the costs whilst the benefits are shared with shareholders
who do nothing. Selling shares is easier than trying to influence managements. The situation is different for large institutional shareholders. Since such shareholders often have large numbers of shares in a firm, they may be able to influence the firm's managers. The large shareholdings also allow a substantial proportion of the benefits to accrue to their funds.
Evidence in support of the effectiveness of institutional investor activism comes from Gillan
and Starks (2000) who found that corporate governance proposals from institutional investors
received more votes than those sponsored by individuals or religious organizations. Hartzell and
Starks (2003) found an inverse relationship between institutional ownership and executive
Because of the pressure of institutional investors, the financial analysts more accurate and balanced recommendations as they are dependant on institutional investors for performance ratings and trading commissions. This could serve to make stock market more internationally efficient. (Keith Redhead 2008).
Conclusion
Institutional investors are important to financial markets, because they bring a huge amount of investments to the firm which is necessary for capitalization. The presence of institutional investors in the firm has a profound and positive implication of the financial health of the firm whether perceived or real and a positive influence of the price of the stock. In many ways institutional investors affect stock market liquidity and volatility and influence the management and operation of the firm.
According Keith Redhead (2008) most investment by individuals carried out through institutional investors accounts for around 75% of the stock market investment. The investment behaviour of the institutions therefore has considerable significance importance to financial market. It might be though that this dominance of institutional investors would introduce considerable rationality to the financial market.
Some economists have argued that changes in the money supply are major driving forces for share prices. It is further argued that institutional investors form an important element in the transmission mechanism whereby money supply changes impacts on financial markets. In particular attempts by institutional investors to maintain their preferred ratios of fund to shareholdings may result in the ratios being maintained through the medium of shares price movements.
