The rise of institutional investors in financial markets over fifty years

Institutional Investment

Over the last 50 years, institutional investors have become increasingly dominant in the marketplace. This is because a large number of individual shareholders are lacking the sophistication or knowledge to understand what is happening. Instead, they are turning to professionals who can help them to actively manage their money. At the same time, institutions have been pooling their funds together to reduce risks and increase returns. (Redhead 2008)

Evidence of this can be seen by looking no further than Redhead (2008), who found that this is accounting for 75% of transactions in the public markets. This is up from 1963 figures, which are highlighting that 54% of all publically traded companies were owned by these types of shareholders. Moreover, Redhead observed that this kind of activity is continuing to increase with him saying, "In the United States net cash flows into equity mutual funds grew from $13 billion in 1990 to $310 billion in 2000. In the same period the number of investor accounts rose from 22 million to 162 million, and the value of the U.S. mutual fund assets increased from $239 billion to $3.962 trillion." These numbers are showing how institutional investing has increased dramatically since the mid-20th century. (Redhead 2008)

To fully understand how this is taking place requires focusing on: the growth / development of the institutional investor and their role in the financial markets. Together, these elements will highlight how this type of shareholder has become so dominant in the marketplace. This is the point that their importance will be determined.

The Growth and Development of Institutional Investors

Like what was stated previously, the growth and development of institutional investors has been continually increasing. This is because they can bring with them tremendous amounts of working capital that can be used to provide additional financing to firms (i.e. private equity). One of the main reasons why this is occurring is there has been a liberalization in ownership rules for these kind of investors. (Davis 2002)

Evidence of this can be seen by looking no further than observations from Davis (2002) who said, "Proportions of equity held by institutional investors -- pension funds, insurance companies and mutual funds -- are rising across all OECD countries. Meanwhile institutions are becoming more influential in corporate governance, even in bank-dominated countries, inter alia due to international investment and pension reform." (Davis 2002)

Moreover, the increase in pension funds and the types of investments they can purchase has been continually rising. This is because there is a focus on providing these investors with greater tools that can be used to diversify their assets. According to Vittas (1998) these reserves are sent mainly to mutual and private equity funds. They invest in areas that can provide better long-term growth and appreciation for investors. This has resulted in these funds collecting more assets under management with this accounting for 50% of GDP growth inside the United States. These transformations have been taking place from: changes in the tax code, the kind of products that are sold to customers and reduced barriers for investing in various countries. (Vittas 1998)

These factors are showing how the growth of institutional investors is occurring from a liberalization of asset classes that can be purchased. This is because there are tremendous amounts of additional financing they can provide to start ups and established firms (which are in need of working capital). At the same time, the changes in the tax code have made it easier to purchase different types of securities. (Vittas 1998) (Davis 2002)

These elements are allowing investors to receive a larger return over the long-term and they are helping to protect against various kinds of risks. As a result, the rising dominance of institutional shareholders has dramatically increased the need for additional financing, the liberalizing of ownership rules and to enhance returns / protect against uncertainty. Over the course of time, this has made these kinds of shareholders more dominant inside the financial markets. (Vittas 1998) (Davis 2002)

Institutional investors and financial markets

To fully understand the role that institutional investors are playing in these areas requires carefully examining how they are supporting the current system. This will be accomplished by focusing on: shareholder activism / corporate governance, how they are reducing asymmetries, their contributions to liquidity and the way they are influencing volatility / short-term trading decisions. These elements will highlight the function of institutional investors in the financial system

Shareholders' activism and corporate governance

Institutional investors are playing a significant part in helping to improve activism and corporate governance inside many firms. What is happening is these shareholders control large amounts of common stock, corporate debt and other asset classes. When they feel that changes need to take place is the point that they can use their position to influence the board of directors and the officers who are chosen to run the company.

According to Smith (1996), this is having a positive impact on the kinds of policies that are introduced and the independence of the board of directors. Evidence of this can be seen in a study that was conducted about their influence on firms with him observing, "The role of institutional investors leads to shareholder activism and it analyzes the effects on the target firms governance structure, shareholder wealth and operating performance. The size and level of institutional holdings are found to be positively related to the probability of being perused. Seventy two percent of firms focused on or after 1988 adopted proposed changes. Moreover, shareholder wealth increases for companies that engage these practices and it decreases for firms that resist." (Smith 1996)

This is illustrating how institutional investors are having a dramatic impact upon the types of policies and procedures that are introduced. In the future, these companies are more responsive to their needs and have greater amounts of transparency. This reduces the possibility of risks increasing by having practices in place that will meet the objectives of shareholders.

Reducing the information asymmetries

Another benefit can be seen in the way information is disclosed to stock and bondholders. In this particular case, large institutions have the ability to analyze their positions and determine the underlying amounts of risk. If there are practices that could increase volatility, many will often focus on pushing the board of directors to implement changes that will enhance transparency.

For instance, Bhojraj (2003) found that those companies with larger amounts of institutional investors will provide them with more information. This helps everyone to accurately analyze the potential hazards of investing and the long-term impact it will have on their financial position. Evidence of this can be seen with Bhojraj saying, "The implementation of corporate governance mechanisms is directly related to higher bond ratings and lower yields. This can reduce default risk by mitigating agency costs and monitoring managerial performance through reducing information asymmetry between the firm and the lenders. We find that firms with greater institutional ownership and stronger outside control of the board enjoy lower bond yields and higher ratings on their new debt offerings." (Bhojraj 2003)

This is showing how institutional investors will force firms to provide greater amounts of information to them. When this happens, everyone can make more informed decisions about their financial condition and ability to address a host of challenges. It is this point that they will have confidence in the management and practices they are utilizing. This will lead to lower bond yields and higher ratings.

Institutional investors and the short-termism theory

However, one the biggest criticisms of the role of institutional investors is they are encouraging companies to focus on meeting short-term objectives. This is because all investors want to see an increase in their profit margins. When this happens, the price of the stock will move higher from these favorable perceptions. During the annual proxy vote (for the board of directors), this ensures that they will be reelected to their position by having large institutions on their side. These individuals will hire managers who are able to achieve the Wall Street estimates. (Palley 1997)

In situations where the company is dealing with declining earnings and stock prices; they can change the management team and who sits on the board. This is because these institutions are seeing negative returns. To reduce their risks and improve performance, they will replace executives with someone who can achieve these objectives. (Palley 1997)

This kind of short-term thinking is problematic, as it will limit the focus of management on meeting these goals vs. The longer term benchmarks. When this happens, there are increased amounts of volatility and firms are engaging practices which can hurt performance. This can cause the price of stock to have tremendous amounts of volatility. (Palley 1997)

Summary

Clearly, institutional investors are playing a major role in the financial markets. This is occurring through: increased shareholder activism / governance, improving transparency / disclosures and enhancing liquidity. These factors are important, as they will help companies to become more open and capable of receiving the working capital they need. When this takes place, these organizations can play role in assisting these corporations in meeting the demands of customers.

However, at the same time these stockholders are interested in the short-term financial results. This is because they want to see the value of their investments continually increasing. Over the course of time, this means that corporations will engage in practices which are hurting their ability to deliver long-term growth to investors. As a result, institutional shareholders are having positive and negative impacts on the financial markets.