Institutional Investors: Varieties and Typical Traits

Institutions include corporations, trusts, or other legal entities that invest on behalf of groups or individuals, including both current and future generations. Institutional investors carry considerable influence over the capital markets due to their size, scope, and structure. This reading reviews the most important characteristics of institutional investors and often will contrast them with individual investors. The institutions discussed in the CFA curriculum include:

• Pension plans.
• Sovereign wealth funds.
• Endowments.
• Foundations.
• Banks.
• Insurance companies.

Common Characteristics

Before diving into each type of institution, this Los will review the basic characteristics that are common to all institutions. Including:

1. Scale: Refers to the relatively large amount of investable assets at an institution as compared to a retail or high-net-worth investor. Depending on the size of the institution, investable assets may range anywhere from $25 million to $10 billion. Larger institutions are able to enjoy some advantages such as hiring the best investment management talent, or making large allocations to private equity or real estate assets, which often have high minimum investments. However, the largest institutional investors, however, may experience disadvantages as well. For example, they might be unable to invest in certain niche investments like venture capital (“C”), in which the smaller allocation may not be meaningful in size or worth the higher fees. Large institutional investors also face the costs of market impact given their sizable trading orders.
2. Long-term investment horizon: Some institutions, such as foundations, sovereign wealth funds, have unlimited time horizons. Other institutions such as pension plans and insurance companies have very long time horizons. This is one of the key factors that enables them to take on more risk as compared to individual investors.
3. Regulatory challenges: Increased regulation often allows institutions to enjoy a tax-exempt or tax-advantaged status. These regulations vary by jurisdiction and thus the specifics are not required exam knowledge. Some examples of regulatory frameworks and organizations include:

   United States: Employee Retirement Income Security Act, Generally Accepted Accounting Principles, Freedom of Information Act.

   United Kingdom: Pensions Act, Finance Acts.

   South Korea: Employee Retirement Benefit Security Act.

   Australia: Superannuation Industry Act.

   International: International Financial Reporting Standards, International Organization of Securities Commissions.

   The goals and desired outcomes for the legal and regulatory frameworks include:

   • Investor protection.
   • Safety and soundness of financial institutions.
   • The integrity of financial markets.
4. Governance framework: Refers to a more complex setup of individuals who make investment decisions on behalf of the institution. These structures tend to be formal in nature and include defined roles such as the board of directors and an investment committee. These professionals are tasked with guiding the investment decisions of the institution, including defining the risk parameters, creating an investment strategy, and monitoring the investment performance. This can include the hiring of specialized investment staff to make tactical asset allocation decisions. Pension funds, sovereign wealth funds, endowments, and foundations often outsource most of the investment management to external managers, while banks and insurance companies do their own investing, risk budgeting, compliance, and balance sheet management activities internally.
5. Principal-Agent issues: Refers to potential conflicts of interest or dis-aligned incentives between owners and employees. In the context of institutional investing, this often manifests itself when external investment managers have burdensome or expensive fee structures that provide them with high fees regardless of performance. This has led to an increased desire for more fee transparency and better fee structures in the hedge fund and private equity industries.

Question

All but which of the following are typical goals for regulatory frameworks?

1. Investor protection.
2. Safety of financial institutions.
3. Fragmentation of financial markets.

Solution

The correct answer is C.

Fragmentation of financial markets means a less cohesive market. This is not a goal of regulation. One example of a push to the contrary is the desire to merge IFRS and US GAAP, making them more similar and globally cohesive accounting frameworks.

A is incorrect. Rules and regulations globally seek to protect investors and the local economy. Investor protection lays out rules that make sure investors are not mistreated in any way, such as being sold financial products under false pretenses.

B is incorrect. In the same way, the safety of financial institutions also protects the local economy. One example is capital reserve requirements for large banks. When banks have enough capital on hand, it helps reduce exogenous shocks such as sudden inflation or other financial crises that could cause a run-on bank. This means that the banks stay viable, reducing the risk that they could go out of business, leaving many unemployed at the same time, and leaving citizens with less access to financial intermediary services.

Portfolio Construction: Learning Module 5: Portfolio Management for Institutional Investors; Los 5(a) Discuss common characteristics of institutional investors as a group