Institutional vs Retail Investors: Why Individuals Are at a Disadvantage
All investors have the same objective: to minimize risk and maximize return. But do all investors have access to the same tools to achieve this? Can retail investors compete with institutional investors when they are faced with setbacks such as:
- Less thorough research
- Limited technical understanding of how the variables relate
- Less access to the management team
- Lack of financial investment training and experience
- Fewer investment options available to them
And most importantly they do not understand the drivers behind a promotional machine set out to extract their hard earned cash from them.
We layout the key differences between retail and institutional investors and how retail can turn the odds in their favour to allow them to make better investment decisions.
What is an investment?
Investments are something you buy or put your money into to get a profitable return.
An investor has a portfolio which includes all their assets, with the aim of holding a diverse range of different asset classes to help lower the risk of the overall portfolio. eg: If you invest all your money in one company and it fails, you lose all you money. However if you invest your money in 10 companies, the chances of all 10 companies failing at the same time is much less. This is called a blended portfolio approach.
Some investors go further and have non correlated investments.
e.g. if you had invested in 10 leisure sector companies during the Covid pandemic, you may have seen all 10 investments fail. However, if you chose to invest in non-correlated sectors such as leisure, mining, pharmaceuticals and automotive, these reacted and were affected differently, in a non-correlated way.
What is an investor?
An investor is a person or organisation that puts money into financial schemes with the expectation of achieving a profit.
There are 2 main categories of investors: Retail and Institutional investors.
Whilst they both have the same objectives, both types of investors have 2 very different paths towards making an investment. Most conversations are centered around institutional investors, whilst retail investors are left to fend for themselves.
What are the 2 types of investors?
What are the main differences between institutional and retail investors?
An institutional investor is a large organisation that invests money on behalf of other people by using pooled resources to trade in large enough quantities to qualify for lower fees. They also have access to private placements; a sale of securities to a preselected number of individuals and institutions. They are relatively unregulated compared to sales of securities on the open market.
Types of institutional investors
An endowment fund is a financial asset, typically held by a non-profit organisation, which contains the capital investments and related earnings leveraged by the non-profit organisation to fund the overall mission.
The primary purpose of the fund is to ensure the long-term financial health of the non-profit organization and its beneficiaries.
An example is a University Endowment Fund which consists of money donated to academic institutions that may be used for research, new buildings and scholarships. The value of the University of Cambridge endowment fund most recently was £3.4 billion.
Banks will pool equity capital from shareholders, gather additional deposits, and invest the cumulative money into balance-sheet assets. Their investment goals are the same as those of insurance companies.
A company that pools money in a ‘portfolio’ from many investors and invests the money in securities such as stocks, bonds, and short-term debt.
They are operated by professionals who allocate the fund's assets to produce capital gains or income for the fund's investors. They give individual or small investors access to professionally managed portfolios of equities, bonds, and other securities.
In the United States, 46.4% of households own mutual funds, run by 7,945 firms.
Hedge funds were originally structured to hold both long and short stocks.
The positions were therefore "hedged" to reduce risk, so the investors made money regardless of whether the market increased or decreased.
These funds are limited to wealthier investors because they come with higher fees paid to their managers and involve more risk than other types of investments.
The value of assets managed worldwide by 735 hedge funds is 3.11tr U.S. dollars, with 1.24tr accounting for New York.
A pension fund is a plan, fund, or scheme which provides retirement income.
They typically have large amounts of money to invest and are the major investors in listed and private companies. They are especially important to the stock market where large institutional investors dominate and most major banks will run a pension fund.
An insurance company protects individuals or businesses from financial loss.
They invest premiums in order to generate a profit and re-invest in a wide range of assets. Insurance companies invest in many areas, but mainly in bonds - the safest of all investment categories.
The total revenue of the life/annuity insurance industry in the United States in 2019 was 922.3 billion U.S. dollars.
Do institutional investors invest their own money?
No. An Institutional investor works on behalf of its customers, clients, members and shareholders to buy and sell blocks of stocks, bonds, or other investment securities.
Institutional investors are assumed to be more knowledgeable than the average retail investor as they have access to resources, specialised knowledge and extensive research that is not available to retail investors.This means that they are subject to less restrictive regulations and have access to exclusive securities.
Buying and selling large positions by institutional investors can create supply and demand imbalances that result in sudden price movements in the market, affecting the investment decisions of retail investors.
Can institutional investors earn their own money from investing other people's?
An investment manager decides which assets to buy in order to build a diverse, managed portfolio. The investor usually charges an asset management fee and takes a percentage of the profits made each year. Profits will vary but there is potential to make a lot of money for their fund.
Is the number of institutional investors increasing?
Yes. In 1950 institutional investors accounted for 8% of stock investments and by 2010 institutional funds in the market had increased to 67%. In 2020, this figure has increased to over 80%.
This is because more people now participate in the capital markets through pooled-investment vehicles, such as mutual funds and exchange traded funds. The growth in the proportion of assets managed by institutional investors has been accompanied by a dramatic growth in the market cap. of listed companies.
Why are institutional investors important?
Institutional Investors are an essential source of capital in the economy. They provide large chunks of capital to companies that fulfil their requirements without having to depend on a large number of small investors.
What is an accredited investor?
An accredited investor is a high net worth person or business that is allowed to deal in securities that might not be registered with financial authorities.
They are entitled to this privileged access by fulfilling at least one requirement regarding their income, net worth, asset size, governance status or professional experience.
Some high-net-worth individuals can operate under the same trading rules as institutional investors. Examples of accredited investors are:
- A charitable organisation with assets exceeding $5 million
- A corporation or partnership with assets exceeding $5 million
- An individual with a net worth of at least $1 million
- An individual with income of over $200,000 for two consecutive years
Warren Buffett, CEO of Berkshire Hathaway, is widely regarded as the most successful individual investor in the world based on the amount of capital he started with and what he was able to grow it into. When he started his partnerships, he had a personal savings of around $174,000. Today, he has turned that initial amount into roughly $50 billion!
On a smaller scale, as of 2020 there are 13,665,475 accredited investor households in America.
Warren Buffett at the 2017 Forbes list of 100 Greatest Business Minds
A retail investor (also known as an individual investor) is a non-professional investor who buys and sells through brokerage firms or other types of investment accounts.
Retail traders are more likely to invest in small-cap stocks due to their lower price points which means they can buy lots of different stocks to achieve a diversified portfolio.
How can retail investors invest?
A brokerage firm conducts transactions on behalf of a client. Some brokerage firms only conduct transactions, while others also offer different types of investment advisory services.
Brokerage firms make profit from commissions on orders given, usually collecting a percentage of the value of each transaction, though some charge flat fees. An investor can make transactions via telephone or online.
There are several types of brokerage firms offering a wide range of products and service:
- A full-service brokerage which includes financial advice
- Discount brokerages which are online platforms for DIY investment
- Robo-advisors which are automated advisory platforms offering digital investment management services provided by algorithms
Retail investors will often want to plan for their future or retirement and set up a Retirement Account as a tax-efficient savings plan to use to build up a pot of money for support in retirement.
Retail investors who want to become an active trader in individual stocks will set up an online trading account. Retail brokers provide day traders with margin accounts and educational resources which are designed to help traders understand the market and ultimately increase their trading volume.
Do retail investors invest their own money?
Yes. Retail investors often trade in smaller amounts of money and less frequently than institutional investors, purchasing securities for their own personal accounts rather than investing on someone else’s behalf.
These investors are usually driven by personal goals, such as saving for a large purchase, children’s education or their retirement. And occasionally intellectual pursuit.
But let's be clear, whatever the reason, investing must be lead by cold, unemotional decision making. Institutional investing is lead by this mantra which is easier because it is not their money. The people making decision are using other people's money. They have a salary, usually a good one. They do however get performance bonuses either as an company or an individual, which can affect their decision making. But their first rule is do not lose the money.
Hedge fund managers and fund managers charge a fee of 2% on money under management which safety net for them. They can also charge a fee of 20% on profits, but usually once the profits are over an agreed hurdle rate of 15%. So you can see why institutions tend to be more cautious and calculated. They make money no matter what.
Retail investors are using their own money and tend to be more emotional because it's their own money.
It affects their family, their needs and they may feel it reflects on their abilities.
If you are a retail investor take comfort in that one of the best investors in the natural resources, Rick Rule of Sprott, said they were happy if they got it right 50% of the time.
How many retail investors are there in the world?
Retail stockbrokers and investment platforms have reported record trading volumes, together with strong new business numbers. The retail investment space is enormous with individuals investing worldwide, but no survey has yet been conducted to estimate the number of retail investors globally.
Why are retail investors important?
Retail investors provide capital to companies when other sources of financing are difficult to find.
Retail investors tend to invest for a longer period than institutional investors and provide a long-term and stable source of investment so play a crucial role in building the stock market and the economy of a country. If the interest of retail investors is protected, the business will get a stable position and help to build the economy.
There has been a dramatic stock market recovery since March from the contribution that retail investors have made. Throughout the Covid crisis, UK listed companies have been raising equity in large amounts to help their balance sheets and put themselves in a better position for growth. A good example is the online supermarket Ocado - whose shares have risen 66% from 2 January to 15 June.
Do retail investors have access to private placements?
More retail investors will be gaining access to private funds and companies as new rules were approved by the Securities and Exchange Commission (SEC) in August 2020. Individuals who don’t meet minimum levels of income and net worth in the ‘accredited investor definition’ will be allowed to put their money in private funds if they have certain professional certifications, designations and other credentials from accredited educational institutions.
While more companies are now letting retail investors get involved, it still isn’t easy for retail investors to buy the new shares that are typically priced at a discount.
Shares are ‘snapped up’ as soon as they become available and often aren’t advertised as companies or their brokers have first approached big institutional investors to offer them first pick of the new shares. This means the shares are sold and the placing is closed before many, if any, retail investors get a look in. The company gets their money and the broker earns their commision so they are happy, whilst retail investors haven’t had a chance to get involved in the profits.
Do retail investors get the same opportunities as institutional investors?
No. Individual investors are thought to be less knowledgeable, less disciplined and less skillful than institutional investors so they are often presented with more risky investment opportunities. Critics say that retail investors have fewer resources, skills, talent, and technology available to search for good investments as compared to institutional investors.
Because of their small purchasing power, retail investors often have to pay higher fees on their trades, as well as marketing, commission, and annual management fees.
There are also strict rules on the entities that work with retail investors which include:
Assessments of risks
There is a concern regarding safeguarding the interest of retail investors to protect them from fraud & scams and make stock markets safer and more transparent.
A brokerage fee is charged to facilitate trading or to administer investment on retail accounts. The 3 main types of brokers that charge brokerage fees are full-service, discount, and online. These brokerage fees will differ depending on the service. Regulations require investment fees to be more prominently disclosed, yet it is still very confusing to retail investors to work it out.
Safeguarding of client assets
Firms including brokers, investment banks and custodians which hold or control client assets must report the value of their assets. They must follow rules set out in the Client Assets Sourcebook (CASS) if they hold or control client money. This is to keep client money and assets safe if firms fail and exit the market. To reduce the risk of financial loss they should identify, assess and mitigate the risks.
7 risk management tips for new investors
Retail investors do however take on a risk by doing everything for themselves. It is important to make a plan with your aims and objectives. Here are 7 risk management tips for new investors:
- Know what you can afford to lose.
- Make a plan - aims and type of risk.
- Keep an emergency fund.
- Understand the different types of risk - emotional, behavioural and mathematical.
- Don’t try and time the market. It’s time in the market rather than timing the market.
- Diversify your portfolio. Don’t put all your eggs in one basket.
- Remember taxes and fees.
Things are looking up for retail investors
There is now more accessible information available for retail investors, brokerage fees have fallen, and mobile trading enables investors to manage their portfolios from their smartphones. Many retail funds and brokers have low minimum investment amounts or deposits which makes it easy to start investing.
Retail investors often do not have access to the types of company reports that are paid for by institutional investors, costing them from $20,000 to $100,000. Research companies and brokers are restricted by regulators in sharing that information with retail investors, which puts retail investors at an immediate disadvantage. The level of detail and analysis that an institution has is far superior to anything a retail investor can access.
Sometimes the reports are paid for by the company itself. This has two implications:
- If the research company being paid to write the report wants the business of the company again the reports tend to be heavily skewed to the positive, and avoids talking about problem areas. 2.
- This controls the narrative and perception which makes investing decisions biased and positive outcomes harder. The company has bought the silence and complicity of the research company.
Brokers too, will write company reports. These also tend to be positive and glowing reports, but for different reasons.
The broker tends not to be paid directly for writing a report, but indirectly is able to make money. The company will often pay for consultative services and distribution of the report. Having created a report or story, the broker to makes money by selling the story to their clients. It doesn't matter to the broker if they believe the company is good or bad, because the broker charges a fee. This is usually a combination of cash and warrants, as a percentage of the money placed by the investor ie: 5% as cash and 5% equivalent as warrants. This is their business model. Yours will be different.
So let's think about this. If you invest $10,000, the broker gets given $500 of your money in cash and warrants to the value of $500. So company has $9,500 minus contribution to fees to legal, administrative, marketing and expenses. Typically 10% of your money does not get spent enhancing the value of the project. So from that perspective, one could say your money starts from a negative position and has to work really hard to get back to where it started.
Less information available = worse investment decisions