The Increasing Importance of Institutional Investors - Coursework Example

Explain the increasing importance of al investors in todays financial systems. How does the growth of al investment affect the functioning of these systems? Institutional Investors Institutional investor is the name that is the buzz of the financial sector now-a-days. Who are the institutional investors? To explain in simple terms, institutional investors are persons or organizations who trade in large quantities of shares of securities. In other words institutional investors are people or organization who invest large sum of money in different companies. They are of the following type: Insurance companies Retirement funds Hedge funds Pension funds Mutual funds Unit Investment Trust Institutional investors are free from heavy regulations because it is commonly believed that they can protect themselves as they a better knowledge about the market conditions. This is because they act as specialized and expert investors on behalf of the others. As the institutional investors have voting rights in an organization, they can influence the decisions and working of the management of those organizations. They can advice the corporations in the matters of corporate governance. It can be said that institutional investors are sometimes referred to the elephants as they account for almost half of the volume of trades on NYSE. Financial System In today’s era financial system plays a vital role in the mobilization of funds. They play an important role in the allocation of these funds so that they can be used productively to benefit the economic growth. The financial systems’ operates on the basis of functional autonomy and operational flexibility to enhance efficiency and profitability of the whole system. A financial system is used to support the financial functions. These financial functions include financial events, financial information important for any agency or corporation. Growth and Development of Institutional Investors Before analyzing the importance of the institutional investors, it is important to know how the growth and development of these institutions has affected the overall importance of it in the financial systems. The institutional investors have grown steadily over the past few years not only in United States but all over the world. The above table taken from a research report ‘Development of Institutional Investors’ suggests that institutional investors have grown due to the overall growth in financing of the above mentioned economies. The size of the institutional investors has constantly grown as compared to the growth of banks. Another table (below) taken from the same source that is ‘Development of Institutional Investors’ show that the pension funds have grown more than any other type of institutional investor followed closely by mutual funds. Two economic conditions can be used to determine the growth of the institutional investors. These are the supply and demand side factors that are responsible for the rapid growth of the institutional investors. According to the supply side factor, institution investors have fulfilled the functions of the financial systems by providing its services more efficiently than any other financial institution. According to the demand side factor, institutional investors are able to fulfill the advance requirements of investments of households. Both factors have added significantly to the growth institution investors. This is because that they provide a superior quality services given the current technology better than the other institutions in the financial systems. Another factor leading to the rapid growth of the institutional investors is the public’s demand for easy transferable and highly liquid securities and diversification that these securities offer. According to Chakravarthi in his article, he points out that over the past few years investments like leveraged buyout finds, venture capital and so on have had an increasing impact on the growth of the institutional investors with almost $70 billion commitments for US and Canadian pension funds. (Chakravarthi, 2008) In a chapter Institutional investors and domestic debt, it is said that in developed economies, pension funds and insurance companies are the largest institutional investors although investment in mutual funds has being growing at a faster pace. The graph on the right depicts the growth of mutual funds and pensions in the emerging markets and developed markets. Growth Affecting Function of Financial Systems In today’s growing economy, institution investors are playing a vital role in the financial systems. The growth of institution investors have changed the functioning of the financial systems to a great extent. Many financial analysts have asked the question that whether or not institutional investors have brought instability in the financial systems? The answer would be no. This is because institutional investors are the channel through which investors can access the financial markets. (Chakravarthi, 2008) Some of the functions of financial systems have been discussed below: 1) Institution Investors and Clearing & Settlement Clearing & settlement is a way to facilitate exchange of goods and services with credit cards, wire transfers, cash cards and so on. With the growth of the institution investors, mutual funds now also offer transaction accounts that can be redeemed at par. They were able to do this because of innovations and technological progressions in the money markets. It is also believed that the structure of the market has being changed by the institutional investors in order to facilitate both financial and non-financial institutions to hold, obtain and transfer liquidity easily. In addition to that, clearing and settlement usually has problems in dealing with the clients. They may not have the capability to carefully monitor the interests of the investors. However, institutional investors can deal with these issues of corporate governance more easily because of their influential power. (Development of Institutional Investor, pg 22) According to Vittas, institutional investors have promoted clearing and settlement facilities that are more efficient than the previous ones. They have also established central depository agencies that facilitate safekeeping services and book-entry systems. 2) Institutional Investors and Household Funds Pooling funds from households is used as a mechanism by the financial institutions. But institution investors are experts in pooling funds because of their size and economies of scale. Therefore they are in competition with the banks because investment in a constant supply of assets. 3) Institutional Investor and Security Market Equity market in the US has changed recently due to the growth of institutional investors. Both of them are being closely regulated by the SEC. According to the paper delivered by Vittas in 1998, institutional investors have provided a powerful motivation behind the development of the securities market. Institutional investors have acted as a countervailing force to the position of commercial banks and have therefore become the promoters of competition and efficiency in today’s financial systems. The changes in the financial systems brought by the institutional investors are far greater than changes that banks and securities market have brought in past years. These gains of efficiency in the market are also due to the investment in non-government securities. They have also modernized the capital markets, enhanced financial innovation and transparency and strengthened corporate governance. It can also be viewed that the growth of institutional investors has increased the competition in bidding for the corporate issues of the securities. Before the introduction of institutional investors, different investment banks acted as sole managers for underwriting and distribution of new issues of large corporations. But after the growth of institutional investors, corporations could now place new issues directly with them due to large financial resources and could also help the corporations in setting up ‘Dutch auctions’ which could attract different syndicates of bidders. Corporate raiders were given a boost in the 1990s due to institutional money. This money was also used in leveraged buyouts, growth of high-return securities. All these activities led to an increase intense competition in different markets. Due to the growth of institutional investors, new startup firms were also able to grow as institutional investors supported venture capital and private equity. Institutional investors hold more diverse securities in the international markets. This is generally high than their preference of holding fixed-income securities. Another change in the functionality of the equity market brought by the investors was decline in costs related to new issues and trading. As the institutional investors were the major shareholders in different companies, they had a narrow spread for new issues. This resulted in low marketing costs as well as examining costs for new issues. Trading commissions fell due to the strategy of bloc trading introduced by institutional investors. Besides the above factors that brought changes in the equity market, several other securities introduced by the institutional investors are also responsible for the change. With the growth of institutional investors, mortgage securitization also grew. This helped in the diversification and liquidity of mortgage portfolios held by commercial banks and other institutions. Due to the securitization process, institutional investors are the owners of almost one-third security agencies in the financial system of the US. Other products that led to the innovation in the equity market were futures contracts, pension funds and index options. All these products provide a hedging against the downside risk of equity investments thus providing participation in the growing potential of the equity market. This increase in securitization has led to investors becoming more dependent on the security-based finance rather than previously depending upon banks and inside investors. The securitization process of the institutional investors have given a new source of diversification to the households from whom costs of portfolio on individual basis is high and prohibitive. According to the paper presented by Vittas, institutional investors can face the agency problems more head on as they are professional trained management. Because of this, they are in a better position to provide rules that protect the investors’ interests. These rules can include regulations on takeovers, changes in corporate controls, insider trading, new issues and audit of the companies. 4) Institutional Investors and Market Trading With the growth of institutional investors, modern and efficient trading facilities have been established. These facilities cover everything from trading to facilitating central depository agencies. Trading systems can be organized in countless ways but institutional investors have given more effective and efficient trading floors. The trading systems are more efficient because they have lower transaction cost, lower volatility, high transparency and liquidity. The bloc system of trading has abolished the concept of minimum commissions not just in the US but across the globe. Trading has become largely exogenous. Trading is now normally presupposed like liquid markets must exist so that the investors can hold securities. The prevailing trading systems show that trading may result from herogeneous assessments as institutional investors lay emphasis on portfolio churning. 5) Institutional Investors and International Financial System The key change in the structure of international financial system has being brought about by the asset management industry of the institutional investors. The changes in international financial systems are related to market turnover and stability, issuance of securities, international capital flows and so on. Although asset management industry has grown, still only a small share of asset portfolios of institutional investors is represented in international investments. This is due to high transaction costs as well as information cost, exchange rate risk, government regulations and tax considerations. According to Vittas, assets managed by the institutional investors in North America, Europe and Japan collectively amounted to $20.9 trillion. The introduction of euro currency might lead to much higher levels of international diversification in euro markets by the institutional investors. Importance of Institutional Investors Institutional investors like other financial institutions in the system, provide a way to pool risk and to give a trade-off between risk and return. They can do this either by holding domestic securities in their portfolio or a combination of domestic and international securities. According to Andres, the importance of institutional investors in today’s financial systems is in regards to the following contributions that they make in the system: Institutional investors are responsible for generating a demand for long-term corporate bond at fixed interest rate They provide liquidity to the bond market They contribute to improve the corporate governance of companies Andres has pointed out that “in the United States, which is the country with the most developed corporate bonds market, families only hold 12% of total corporate bonds and 7% of corporate bonds of non-financial companies. This is due to the fact that families and companies prefer to invest through the intermediation of institutional investors, who specialize in collecting information and carrying out financial analysis. Some institutional investors such as pension funds, due to the nature of their liabilities, are natural candidates to demand long-term corporate bonds.” The importance of the institutional investors can be realized by the efficient and effective changes it has brought in the financial systems. It has increased competition in the financial system. Institutional investors are responsible for bringing in new sources of finance in the corporate and financial world. These new sources are easy access to national and international markets, growth of financial intermediaries, and increase entry of foreign banks and so on. All these sources have attracted customers to invest their savings so that they can earn almost risk-free returns. According to Lescrauwaet in the term paper, institutional investors are a very important source for the financial stability in the country. This is due to their growing size, changes in the investment strategies, and relationships with counterparties and so on. The presence of these institutional investors has led to a broad base of opportunities so spread the risk and earn high returns. She argues that because the importance of the institutional investors is growing, this has led to complex and intense inter-linkages between the financial sectors. Due to these new complex financial systems, it is difficult to assess the location of the risk and has increased the contagion risk between the sectors of the financial systems. In the sector of domestic debt market, institutional investors have an important place. This is because institutional investors are an increasing source for financing the central government. According to the data presented in the ‘Institutional investors and Domestic Debt Market’ about one-quarter of central government debt was held by pension funds, mutual funds and insurance companies in the year 2000. The government debt held by the institutional investors had grown to one-third of total central government debt by 2005. The data in the ‘Institutional investors and Domestic Debt Market’ also points out that institutional investors are not a homogenous group with similar investment objectives like that of the government even though they are the most vital and important source for the functioning of the country’s domestic debt market. The link of the institutional investors and the domestic debt market can work as a two-way source for the growth of both the sectors. The growth of institutional investors can be increased if the government uses a debt management strategy and develop a sound market microstructure. This growth of the institutional investors can in return be beneficial to the public debt management. The role of institutional investors in corporate governance is of vital importance. The institutional investors now have a growing importance as corporate owners. Institutional investors have adopted a passive approach to corporate governance according to which they vote with the management and guide the management issues of the organizations. They can sell shares and organizations without significant changes in market price. They emphasize on the strengthening of the corporate governance and they want more discipline with regards to managers being accountable for their work. The institutional investors require more corporate transparency and disclosure to hold the organizations accountable and to calculate the risk involved in their business strategies. The growing importance of institutional investors is a result of their increase in size and functioning. This growth should not cloud the fact that the institutional investors are small as compared to banks in the asset management sector. Also the regulatory framework and accounting framework related to the institutional investors has impacted the links of the institutions with the banks. Also this growing importance of the links between the institutional investors and the banks are a result of some developments that have taken place in the past years. These are the development of the CRT market, growth of financial conglomerates and hedge funds and so on. Conclusion To sum it all up, it can be said that the growth of the institution investors has impacted not only this nation but also the entire world. All the functioning of financial markets in the world has changed due to the beginning of the institutional investors. The investors from around the world have been given an open door to many investment possibilities that the traditional banks and institutions could not offer. The growth of the institutional investors is the proof in itself of how successful this has become in the world of finance and investment. Because of their characteristics, institutional investors are sometimes also called ‘universal investors’. Works Cited Development of Institutional Investors. Paper. August 12, 2008. Institutional Investors and Domestic Debt Market. Paper. August 12, 2008. Blommestein, Hans. Institutional Investors, Pension Reform And Emerging Securities Markets. October 27, 1996.Paper. August 12, 2008. Lescrauwaet, Pim. Links between institutional investors and banks. December 2006. National Bank of Belgium. Paper. August 12, 2008. Raghavan, Chakravarthi. Institutional funds - the main channel for market turbulence. Third World Network. August 12, 2008. Reinstein, Andres. Issues in Building Bond Markets in Developing-Market Economies. August 2002. The Infrastructure and Financial Markets Division of the Inter-American Development Bank (IDB). August 12, 2008. < http://www.iadb.org/sds/doc/IFM-Reinstein-E.ppt > Vittas, Dimitri. Institutional Investors and Securities Markets Which Comes First? June 28–30, 1998. Research Paper. August 12, 2008. Read More