Importance of Institutional Investors for Financial Markets - Essay Example

Importance of Institutional Investors for Financial Markets Assess the importance of institutional investors for financial markets Introduction Institutional investors play a significant role in financial markets by pooling large sums of money and investing them on securities, real property and other investment assets. In the financial market, trade in securities is the most commonly practiced activity. Some of the institutional investors who invest in securities include insurance companies, banks, mutual funds, hedge funds, pension funds, investment advisors and operating companies that invest a percentage of their profits on investment assets. According to Deng and Xu (2011), institutional investors play a crucial role in global capital markets. By 2005, institutional investors contributed 65% of the equity of firms listed in New York Stock Exchange. The importance of institutional investors in the financial market is that they enhance reduced information asymmetry, promote quality corporate governance, improve liquidity, and increase share prices and value in the financial markets (Sias et al, 2006). Institutional investors act as intermediaries in the financial market (Chen et al, 2007). They intermediate between lenders and borrowers, just like banks. They have a significant function in financial markets because they provide economies of scale by increasing returns on investment and reducing costs of capital for business firms (Chen et al, 2007). They pool savings from lenders and give the money to companies who act as borrowers, enhancing smooth operations between borrowers and lenders in the financial markets. They also encourage diversification by pooling savings from many investors (Demirgüç-Kunt and Levine, 1996). They also play a crucial role in reducing agency costs by monitoring corporate behaviour and selecting the profiles of investors. Role of Institutional investors in spreading risks Institutional investors play a big role for the financial markets as highly specialised investors who invest on behalf of others (Chen et al, 2007). A retail investor with a few earnings may not have enough money to purchase a substantial amount of securities. Institutional investors may pool funds from many of such individuals and purchase securities on their behalf (Chen et al, 2007). For example, an employee may have a pension plan with his employer. The employer then uses that person’s pension as an investment in a fund, which then buys shares or any other financial product from a company trading in the financial market. These funds hold a broad portfolio of investments in several companies. Therefore, the fund spreads risk so that if one company fails the whole investment is not lost. Institutional investors such as pension funds and mutual funds play an important role in financial markets by stabilizing markets and funding the long term growth of corporate organisations (Wermers, 1999). They also boost infrastructure and development in the financial markets. The existences of institutional investors who invest in large funds create a large demand for equity by listed companies (Huyghebaert and Van Hulle, 2004). They merge the demand of funds with their supply in order to create a stable flow of funds in the financial markets, maintaining stable prices and reducing inflation in the economy. The increased collection of funds by institutional investors also enables listed companies to acquire enough capital to grow and increase their performance in the financial market. Influence on Stock prices and liquidity in financial markets Institutional investors are also important in the financial markets because they influence the stock prices of firms (Chen et al, 2007). Usually, they cause a positive effect on the stock prices. The institutional investors affect stock prices of firms in several ways. First, they reduce information asymmetry between the listed firm and investors. This happens because firms collect information about firms and use its pool of firms from investors and invest on their behalf; hence individual investors do not have to go around looking for information about firms. As investors collect information, the information is translated to the stock prices of the firm. Liquidity is also an important factor in the financial market, and institutional investors help to maintain high liquidity. According to Huyghebaert and Van Hulle (2004), the deficiency of liquidity has a negative effect on stock prices of listed firms. First, an irregularly traded financial market leads to uncertainty of value increases in the financial market. Institutional investors help in assembling information about the stock market, leading to stability of prices. Less trading in the stock market causes information not to be incorporated into the prices of stock, reducing the uncertainty of stock value. Decrease in liquidity of prices also leads to low interest of investors to invest in the stock. Furthermore, illiquid stock is difficult to turn into cash, so the sellers of illiquid stock are willing to sell the stock in discounted prices. Institutional investors increase the liquidity of firms by regularly trading their stock. As a result, this reduces uncertainty about the stock values, increases the interest of investors to buy the stock, and reduces the cost of trading in the stock (Ahmad and Jusoh, 2014). In this regards, share prices increase and become stable, and the company demands more shares and acquires more capital to enhance growth of its businesses. The liquidity of stock market is enhanced by higher value of asset returns. Illiquid assets therefore require more asset returns which are associated with higher cost of capital for firms. In order to achieve higher stock value and more liquidity, firms attract institutional investors as the main base of its investors. Institutional investors prefer liquid shares because they are used to rebalance investor portfolios over time. Liquidity of shares is also enhanced when institutional investors engage in information collection instead of leaving the task to individual retail investors (Dua and Xiub, 2009). Therefore, institutional investors play an important role in enhancing liquidity in the stock market. It is important to increase the liquidity of shares in the financial market because it increases the confidence of listed firms, increases their demand for shares, and increase the prices of shares. Quality of Corporate Governance Institutional investors can also play the role of investment management in order to ensure that the listed companies stay solvent and exercise effective corporate governance (Connelly et al, 2010). As a result, this enhances stability in the financial market. An institutional investor can buy and sell a large number of shares due to the availability of sufficient funds at their disposal, leading to increased entitlement to voting rights in the company. Therefore, the institutional investor actively engages in corporate governance of the company. By buying and selling shares easily, institutional investors also help companies to stay solvent (OECD, 2011). Generally, investment management from institutional investors involves providing capital for the company and influencing its conduct. Institutional investors also improve the quality of a firm’s governance, which in turn improves the trading of the company in the financial markets and the confidence of investors in the listed firm (OECD, 2011). For instance, institutional investors may enhance reduction in the global tax bill paid by listed companies (Çelik and Isaksson, 2013). When the institutional investors pay fewer taxes on dividends, the listed companies will pay more dividends, leading to confidence level of investors and the share price of the listed company increases. In this case, higher cash payments in terms of dividends by the firm causes low overspending levels by the company’s management. In this regard, the reduction of overspending and the confidence of investors lead to positive effect on the corporate governance of the company. Corporate governance involves the oversight role played by the board of directors on the company management. Shareholders are legally responsible for the oversight of company management because they have the voting rights to vote for the board of directors who oversee the actions of managers and management structures of the company (Cvetanović, 2006). Companies may design conditions that encourage institutional investors to stimulate shareholder activism. One of the ways that corporate management can be improved is by shareholders identifying problems with the management, and then voicing their dissatisfaction without necessarily selling their shares (Patnaik and Shah, 2013). As ownership of publicly traded companies is dispersed among retail investors, the managers of the company acquire a lot of power (Chen et al, 2007). This creates agency problems related to equity. This agency problem argues that although the firm is mandated to serve the interests shareholders as their agent, managers have their own interests to pursue (Njaha and Jarbouib, 2013). Unless strong oversight tools are used, the firm’s managers will use the resources of the firm which are funded by the shareholders to serve their own interests rather than those of the owners. Over time, managers build up a lot of information about the company, relative to the outside environment, which can be used to give them great power. Small investors do not have sufficient resources and incentives to meet the costs and efforts of monitoring the functioning of the board and company management (Uygur and Tas‚ 2014). On the other hand, institutional investors have sufficient incentives to monitor the activities of the board and the management. This has an important positive impact on the overall financial markets because it ensures that the interests of shareholders are taken care of, so that the confidence of investors increase and investment in shares increase, leading to increased liquidity and share value in the financial markets. According to Abdioglu et al (2013), the governance quality of listed firms influences the investment decisions of institutional investors. Corporate governance with low setups leads to low investment by institutional investors. Institutional investors from countries with high quality of corporate governance invest in companies with high quality of corporate governance (Ippolito, 1992). This indicates that institutional investors have an influence in the corporate governance setups of organisations because companies will develop good corporate governance in order to attract institutional investors with large amount of investment. Reducing information asymmetry In terms of information asymmetry in the financial market, Huyghebaert and Van Hulle (2004) argue that information asymmetry causes price discounts for shares. Institutional investors reduce information asymmetry by solving the problem of adverse selection. When share prices are low, companies are not willing to issue new shares in order to finance their investments because they know that the market cannot be convinced that they have underestimated the value of the firm. Outside investors know that better informed agents are interested in claiming that the share prices are low (Froot and Teo, 2008). This information asymmetry results in low stock prices for quality firms. In order to increase the stock price, firms attempt to reduce information asymmetry by issuing their shares to institutional investors who are dedicated to collecting information about share price in the financial market. Information asymmetries increase the cost of capital for listed firms. Therefore, using institutional investors to reduce the information asymmetry is a viable mechanism of dealing with the rising cost of capital. Institutional investors cause fewer information asymmetries in financial markets. Increased visibility of listed firms attracts institutional investors, who then reduce the information asymmetry about the firm’s share prices (Rubin, 2007. As a result, the share price of the companies and their liquidity increase. Unlike retail investors, institutional investors are able to evaluate the value of the firm more accurately. Therefore, when individuals put their money in mutual funds, the mutual funds invest the money in a company’s shares based on the accurate information it has. The individual retail investor would not have invested in the company without necessary information about its true value (Chen et al, 2007). In this regard, institutional investors ensure that firms which would have otherwise been underestimated in the market are determined and provided with funds to grow, leading to a good flow of investments across all firms in the financial market (Kim and Yi, 2015). Generally, institutional investors contribute to the decline of information asymmetry in the financial market, and as a result lead to increased value and liquidity of stocks in the financial market. Conclusion Clearly, institutional investors are important in financial markets. They have sufficient incentives to monitor the activities of management and acquire information about listed companies. The information is used by the firm to assess the listed company’s financial performance on behalf of individual investors. This enhances improved oversight of management in listed companies, enhancing increased quality of corporate governance, increased commitment of managers, high confidence of investors, and increased demand of shares in the financial market. Institutional investors also link lenders with borrowers in the financial markets, reducing information asymmetry and increasing the liquidity of shares in the financial markets. 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