There are two groups of market participants: institutional and retail investors. The majority of market participants aren't small and independent individuals but large institutional investors who manage massive capital.
In this article, we'll explain the difference between institutional and retail investors with some simple examples.
An institutional investor is an organization that gathers money from many individuals (sometimes from other institutional investors) to generate a high rate of return on capital.
Such an organization would typically have more capital under its control than an individual investor, even if he's the richest man on earth. Having money in a powerful pool managed by professionals gives certain benefits.
Historically, legal entities that pooled money were known in ancient Rome as well as in some Islamic countries and, later, in medieval Europe. Ordinary people, religious and wealthy individuals gathered money in pools for charity purposes and donations: to build a new temple, a monument or to finance an educational institution. The idea of institutional investors was born from honorable causes.
However, later, as those organizations acquired a large wealth and possessions (lands, real estate, etc.) they started to be profitable. After a while, as agriculture wasn't that profitable anymore, they moved the capital into other assets such as bonds in Venice, France, and other countries. They learned how to diversify and became a version of modern banks.
An interesting example is The Templar Order (Knights Templar), who started as a religious organization, but then received land, tax benefits and managed to create a powerful financial infrastructure in Europe. Unfortunately, their decline and eventual collapse weren't pleasant.
Institutional investors in their modern form were created quite recently, but in one form or another, they existed for a while.
These days we understand institutional investors as various funds, companies, and banks that manage large capital on behalf of other people.
There is a narrative that institutional investors are those bad and evil market players who manipulate prices and cause collapses by short selling or something, but actually many of them are just pension funds who help millions of ordinary people to retire.
Here are some entities that are considered to be institutional investors:
- Investment companies
- Investment trusts
- Insurance companies
- Endowment funds
- Hedge funds
- Mutual funds
- Pension funds
- Unit trusts and unit investment trusts
- Sovereign wealth funds (state-owned investment funds)
- Educational institutions (college, schools, etc.)
- Portfolio managers / assets managers
Retail investors are independent individuals with a trading or investing account who buy and sell market securities. They are the most numerous market participants, but they are insignificant when it comes to the total trading volume and capital.
There are two types of retail investors:
- A Beneficial Shareholder acts via a proxy (a bank or a broker)
- A Registered Shareholder acts directly without a proxy (non-discretionary portfolio) and holds a proper trading/investing license
Generally speaking, retail investors have better opportunities to make money because they can act independently, however they also face more risks, but after all everything depends on a particular strategy and approach of each investor (conservative strategy, etc.).
One advantage of retail investors is that they often have to pay fewer fees as they manage their assets directly, but in recent years institutional investors’ fees have been decreasing due to the competition and many retail investors still have to pay some fees if they are acting via a proxy. Plus, some funds and investment companies offer low-fee instruments such as ETFs and other products.
Are They Actually That Different?
It's interesting to look at the statistics of how much market capitalization institutional investors hold compared with retail investors:
“An examination of 13F forms on investor positioning shows that the share of the S&P 500 owned by fund managers with more than $100 million in assets has risen from less than 40 percent to above 80 percent by 2017”
So, the share of collective ownership is rising, but there is another interesting trend: more retail (common) investors are purchasing the same instruments like the S&P 500 index as large institutional investors do, and if those two groups behave in the same way what is the difference between them anyway? One might expect that the strategy, the choice of assets and behavior of massive funds with billions of dollars under control, would be different from tiny independent players, but they tend to have more and more similarities. These days the only difference between them seems to be the amount of capital under control.
However, smaller market players do pick riskier stocks, bonds, and other market securities more often, they are seeking a higher alpha and willing to see a higher beta as well just because they can afford to lose their small capital. Many institutional investors would avoid risky investments because they are responsible for many people in the pool and because they develop certain hedging strategies and policies.
The border between these two market participants can occasionally be unclear. The important parts of an investor, both individual and institutional, is the policy, the strategy, and the general philosophy, plus a consistency to follow it.
Institutional investors usually propose several instruments to satisfy the needs of many: risky and less risky ones, local and foreign, etc. That is how they managed to gather a large capital that operates as many smaller groups with different goals and settings.
Which One Is “Better”?
Is it better to act as an individual or to allocate the capital into a fund to maximize the rate of return on capital?
This question is impossible to answer clearly because there are too many variables and questions:
- What are your skills, expertise, and knowledge about the market, trading and investing?
- What is the amount of capital you manage?
- How much personal time do you have for active trading/investing?
- Is it a trusted and reliable fund/company where you are planning to allocate your capital?
If you don't know much about investing and trading and you currently don't have time to learn it, you should definitely find a good company/firm/fund to allocate your savings there. In a case when you don't have much capital, but you have time and you want to learn to invest, you'd probably be better off managing everything by yourself. Also, there is a big difference between various institutional investors and their products: some might do a great job, some might not, and a lot would depend on a particular investment product you'd pick.