Investors, Institutional

BIBLIOGRAPHY

Institutional investors are professional fiduciary entities managing investment portfolios on behalf of their clients as well as for their own proprietary accounts. The major groups include mutual funds, independent investment advisors, banks, insurance companies, foundations, endowments, pension funds, and, more recently, hedge funds.

Mutual funds are traditional investment companies managing investment portfolios for funds’ shareholders. Independent investment advisors are typically associated with large diversified financial institutions (e.g., Lehman Brothers, Bear Stearns) and can invest for their own proprietary accounts as well as manage portfolios for their clients (such as wealthy individuals, pension funds, endowments, etc.). Investments managed by banks are mostly limited to trusts and some pension funds. Insurance companies invest primarily in fixed-income securities. University endowments and charitable foundations are mostly concerned with capital preservation and often outsource all or most of their investment portfolios to professional money managers (e.g., independent investment advisors). Hedge funds are mostly unregulated investment vehicles, which are restricted to qualified wealthy investors and are not required to register with the Securities and Exchange Commission or to report their ownership positions.

Since the 1950s, institutional investing has played an increasingly important role in global financial markets. Professional investors and money managers of the twenty-first century have control over a significantly larger asset base than their colleagues thirty or forty years ago. According to quarterly institutional filings with the Securities and Exchange Commission (Form 13F), both the number of institutional entities and aggregate assets under their management experienced tremendous growth during the second half of the twentieth century. According to Paul Gompers and Andrew Metrick (2001), reported U.S. holdings of large institutional investors (excluding hedge funds) grew from $375 billion in 1980 to $3.98 trillion in 1996. Institutional ownership of the U.S. equity markets grew from less than 10 percent in 1950 (estimated by Friedman 1996) to 27.6 percent in 1980 and to over 61.2 percent in 2005. According to the Conference Board, in 2005 large U.S. institutions controlled over $24 trillion in assets (excluding hedge funds). Independent investment advisors have experienced the greatest growth of all institutions. In 1997 there were roughly six times more independent investment advisors than in 1983 (1,128 versus 195). Most recently, hedge funds outpaced other types of institutions in number of entities, which skyrocketed from about 530 in 1990 to over 7,000 in 2007 (excluding funds of funds), and it is estimated that in 2007 hedge funds controlled between $1.5 to $2.0 trillion assets under management worldwide.

The growth in institutional investments can partially be attributed to the worldwide proliferation of public and private pension plans (e.g., Government Pension Investment in Japan, ABP in Netherlands, CalPERS in the United States) and tax-deferred retirement savings plans (e.g., 401(k), 403(b), IRA). Large institutional investors became active advocates of shareholder interests and corporate monitors (Hartzell and Starks 2003). Blockholders and other large owners play an increasingly important role in corporate governance as well as proxy battles. While some institutional investors are very independent in their voting decisions (e.g., CalPERS), others often rely on recommendations of Institutional Shareholder Services.

For their professional management, institutions earned a reputation of “smart money.” In fact, some institutional investors appear to be able to predict future negative events, such as class-action shareholder litigation (Barabanov et al. 2007) and may also benefit through informed trading at the expense of less-sophisticated individual investors. For example, institutions capture postearnings announcement drift in stock prices (Cohen et al. 2002), participate less frequently in lower-quality seasoned equity offerings (Gibson et al. 2004), select stronger initial public offerings (Field and Lowry 2005), do a better job interpreting both analyst recommendations (Mikhail et al. 2005) and earnings announcements (Ali et al. 2004), and do not trade as often as individuals on misleading “pro forma” earnings (Bhattacharya et al. 2005). Sergey Barabanov and colleagues (2007) show that information advantage of institutional investors stems mostly from their skills in analyzing public quantitative information. Unlike some individuals, institutions seem to refrain from trading on illegal insider information.

Good performance of institutional portfolios is driven by institutions with a short-term performance focus, such as independent investment advisors and mutual funds (e.g., Barabanov and McNamara 2007), whose compensation is based primarily on performance relative to their peers and respective benchmarks. Unlike institutions with a long-term focus (banks, insurance companies, foundations, and endowments), short-horizon institutions possess private information about long-term earnings, which is reflected in short-term prices (Ke et al. 2006). Mutual funds and independent investment advisors are typically more aggressive than banks, insurance companies, and endowments. Consequently, mutual fund managers often choose to invest in relatively risky securities with high levels of ownership turnover (Bennett et al. 2003). While 77 percent of mutual fund managers have been found to be return momentum traders (Grinblatt et al. 1995), bank-managed trusts and pension funds, in contrast, are typically more conservative in their investment policies and do not strongly pursue potentially destabilizing trading behavior such as herding (mass buying or selling of a particular asset) or momentum trading (e.g., Lakonishok et al. 1992). Because they are subject to the American Bankers Association’s Model Prudent Man Investment Act and the American Law Institute’s Restatement of Trusts, managers of bank trusts and bank-managed pension funds are personally liable and aim to ensure that their investments are considered prudent by courts should any litigation arise (Longstreth 1986; Del Guercio 1996). Insurance companies invest only a small portion of their assets in equities and prefer low volatility of returns (Badrinath et al. 1996). Endowment managers display conservative behavior as they typically do not have performance incentives for high relative returns, but may suffer highly negative publicity in the case of poor performance (Brown 1999).

Historically, institutions preferred to invest in large capitalization companies with better visibility and transparency of earnings, revenues, and management, wider analyst coverage, and low transaction costs (e.g., Gompers and Metrick 2001; Falkenstein 1996; O’Brien and Bhushan 1990). With increasing competition among professional money managers, institutional preferences have shifted toward smaller stocks, where they can achieve more benefits from their informational advantage (Bennett et al. 2003), as well as new asset classes (e.g., private equity, venture capital, hedge funds) and developing and emerging markets.

Institutional participation enhances market liquidity, efficiency, transparency, and corporate governance both in developed and emerging markets. The information acquisition activities of institutional investors, for example, stimulate the speed of adjustment to new information (Sias and Starks 1997) and reduce information asymmetries between insiders and capital markets (Szewczyk et al. 1992). Even though aggregate institutional ownership data provides evidence of institutional herding and momentum trading, this behavior appears to be exhibited less by institutions than by individuals and is attributed mostly to trading by mutual funds and independent investment advisors. Overall, institutional investors help mitigate potential instabilities in financial markets by facilitating efficient allocation of resources through transfers of risks and access to capital.

SEE ALSO Equity Markets; Financial Markets; Herd Behavior; Information, Asymmetric; Initial Public Offering (IPO); Investment; Investors; Risk; Stock Exchanges; Transparency; Uncertainty

BIBLIOGRAPHY

Ali, Ashiq, Cindy Durtschi, Baruch Lev, and Mark Trombley. 2004. Changes in Institutional Ownership and Subsequent Earnings Announcement Abnormal Returns. Journal of Accounting, Auditing, and Finance 20: 221–248.

Badrinath, S. G., Jayant R. Kale, and Harley E. Ryan. 1996. Characteristics of Common Stock Holdings of Insurance Companies. Journal of Risk and Insurance 63: 49–77.

Barabanov, Sergey, and Michael J. McNamara. 2007. Institutional Ownership, Bid-Ask Spreads, and Returns on NASDAQ Stocks. Working Paper, University of Saint Thomas and Washington State University.

Barabanov, Sergey, Onem Ozocak, Harry J. Turtle, and Thomas J. Walker. 2007. Institutional Investors and Shareholder Litigation. Financial Management Forthcoming.

Bennett, James, Richard Sias, and Laura Starks. 2003. Greener Pastures and the Impact of Dynamic Institutional Preferences. Review of Financial Studies 16: 1203–1238.

Bhattacharya, Nilabhra, Ervin Black, Theodore Christensen, and Richard Mergenthaler. 2007. Who Trades on Pro Forma Earnings Information? Accounting Review 82 (3): 581–619.

Brown, William. 1999. University Endowments: Investment Strategies and Performance. Financial Practice and Education 9: 61–69.

Cohen, Randolph, Paul Gompers, and Tuomo Vuolteenaho. 2002. Who Underreacts to Cash-Flow News? Evidence from Trading between Individuals and Institutions. Journal of Financial Economics 66: 409–462.

Conference Board. 2007. U.S. Institutional Investors Continue to Boost Ownership of U.S. Corporations. http://www.conference-board.org.

Del Guercio, Diane G. 1996. The Distorting Effect of the Prudent-Man Laws on Institutional Equity Investments. Journal of Financial Economics 40 (1): 31–62.

Falkenstein, Erik. 1996. Preferences for Stock Characteristics as Revealed by Mutual Fund Portfolio Holdings. Journal of Finance 51: 111–136.

Field, Laura, and Michelle Lowry. 2005. Institutional versus Individual Investment in IPOs: The Importance of Firm Fundamentals. Working Paper, Pennsylvania State University.

Friedman, Benjamin. 1996. Economic Implications of Changing Share Ownership. Journal of Portfolio Management 2: 59–70.

Gibson, Scott, Assem Safieddine, and Ramana Sonti. 2004. Smart Investments by Smart Money: Evidence from Seasoned Equity Offerings. Journal of Financial Economics 72: 581–604.

Gompers, Paul, and Andrew Metrick. 2001. Institutional Investors and Equity Prices. Quarterly Journal of Economics 116: 229–259.

Grinblatt, Mark, Sheridan Titman, and Russ Wermers. 1995. Momentum Investment Strategies, Portfolio Performance, and Herding: A Study of Mutual Fund Behavior. American Economic Review 85: 1088–1105.

Hartzell, Jay, and Laura Starks. 2003. Institutional Investors and Executive Compensation. Journal of Finance 58: 2351–2374.

Ke, Bin, Santhosh Ramalingegowda, and Yong Yu. 2006. The Effect of Investment Horizon on Institutional Investors’ Incentives to Acquire Private Information on Long-Term Earnings. Working Paper, Pennsylvania State University.

Lakonishok, Josef, Andrei Shleifer, and Robert Vishny. 1992. The Impact of Institutional Trading on Stock Prices. Journal of Financial Economics 32: 23–43.

Longstreth, Bevis. 1986. Modern Investment Management and the Prudent Man Rule. New York: Oxford University Press.

Mikhail, Michael, Beverly Walther, and Richard Willis. 2005. When Security Analysts Talk, Who Listens? Working Paper, Duke University and Northwestern University.

O’Brien, Patricia, and Ravi Bhushan. 1990. Analyst Following and Institutional Ownership. Journal of Accounting Research 28 (suppl.): 55–76.

Sias, Richard, and Laura Starks. 1997. Return Autocorrelation and Institutional Investors. Journal of Financial Economics 46: 103–131.

Szewczyk, Samuel, George Tsetsekos, and Raj Varma. 1992. Institutional Ownership and the Liquidity of Common Stock Offerings. The Financial Review 27: 211–226.

Sergey S. Barabanov