You probably know what an investor is. If you’ve ever purchased a stock, mutual fund, exchange-traded fund (ETF), or any other security, you’re an investor. Investors come in all shapes and sizes - younger and older, wealthy and modest, sophisticated and novice. In today’s digital world, brokerage accounts can be opened and funded on a phone without any direct interaction with another human. Even teenagers, who are typically disinterested in investing (historically speaking), are now commonly putting money in the stock market through modern platforms like Robinhood.
Generally speaking, investors are categorized into one of the following:
Non-professional individual investors, which include you and me, are retail investors. Although the majority of securities investors are retail investors (in terms of absolute numbers, not trading volume), most retail investors are unsophisticated (lacking significant financial knowledge) and many misunderstand the dynamics of the markets. The short squeeze of Gamestop (GME) stock serves as a good example of this. Some smaller investors made a significant amount of money as GME skyrocketed from roughly $20 per share in early January 2021 to a high price of roughly $480 per share later that month. However, a significant number of investors purchased shares in the $200-$400 share price range, only to see its stock price plummet back down to $50 by mid-February 2021. As quoted in this New York Times article:
” At its highest point, GameStop’s share price was $483. On Friday [February 5th, 2021], the stock was worth $63.77. The trading frenzy — powered by online hype over a rebellion against traditional Wall Street powers — had created, and then destroyed, roughly $30 billion in on-paper wealth.
Many small-time investors who got caught up in the mania as it peaked lost big. Timing a trade perfectly is nearly impossible even for the best stock pickers, so even those who made money missed out on far greater riches if they didn’t sell at the rally’s peak."
While the GME short squeeze was a unique event full of emotion and energy from various parts of society, it’s just one of numerous real-world examples of retail investors losing significant amounts of money. Whether the regulators take actions to prevent a similar situation from occurring is yet to be seen (as of this writing in May 2021), but there’s good reason to assume there will be some updates to the law.
The state administrator, along with other securities regulators like the Securities and Exchange Commission (SEC) and FINRA, are most concerned about protecting retail investors. As you make your way through this material, keep track of all the rules and regulations you learned, plus all of the exceptions (exemptions and exclusions). In most scenarios, you’ll find supervision and regulation exists when retail investors are involved, while there are numerous exceptions when engaging larger institutional investors (discussed next).
An institutional investor exists when a single entity invests a pool of capital (money). There are many examples of institutional investors, including:
In each of these examples, a large pool of capital is managed by a financial professional (typically a team of professionals). While you won’t need to know the specifics of these institutional investors, let’s explore them a bit to build some context:
Mutual funds
If you’ve already prepared for the SIE, Series 6, or 7, you should already know about mutual funds. These are portfolios composed of shareholder funds that are managed by an industry professional. For example, the Fidelity Contrafund, a fund with over $100 billion in assets and managed by Will Danoff. Mr. Danoff is ivy league educated (Harvard and Wharton School of Business) and has been managing the fund for over 30 years. Mr. Danoff and his team invest this large portfolio on behalf of their customers in return for fees from customers (somewhere around $100 million annually).
While the Contrafund is a stock-based fund subject to moderate risk, there are thousands of mutual funds available to investors (7,945 mutual funds existed in 2019). Every mutual fund has its own unique set of risks, benefits, and goals. For investors that don’t have the knowledge or time to dedicate to investing their own money, mutual funds are a good investment option.
Hedge funds
Hedge funds are similar to mutual funds, but are generally only available to wealthier investors. They are large pools of capital often invested aggressively in hopes of high returns for their investors. Hedge funds were a big focus in the media during the Gamestop (GME) short squeeze in 2021, as a few particular hedge funds with large short positions (essentially betting against Gamestop) lost billions of dollars.
Hedge funds typically charge a “2 and 20” fee structure: a 2% annual management fee on assets under management and a 20% performance fee on profits earned. The management fee covers operating costs and is charged regardless of fund performance, while the performance fee is only collected on investment gains, often subject to a high-water mark to ensure investors aren’t charged for recovering past losses.
Pension funds
Pensions once were a common employee benefit in decades past. A pension is a retirement plan offered by employers that promises lifelong payments to retired employees if they meet certain qualifications. For example, an organization could offer to pay their retired employees 70% of their highest annual earnings once they reach 20 years of employment. So, if a retired employee’s highest annual earnings over their career was $100,000, the employer would be obligated to pay them $70,000 annually (usually with cost of living increases annually) through the end of their life.
While each pension plan is unique in regards to benefits and structure, all pensions share the same challenge: ensuring they don’t run out of money (known as an unfunded pension liability). While employers contribute significant amounts of money annually to their pension funds, life expectancies continue to rise. The longer people live, the more capital pension funds must have to fulfill their obligations. This is why many employers hire financial professionals to manage and invest the money in their pension plans. The more they can grow their pension fund, the less they’ll need to contribute in future years.
Nowadays, pension funds are virtually non-existent in the corporate world, thanks largely to the creation of the 401(k). However, the government (both local and federal) still offers pensions.
Banks & credit unions
Depository financial institutions like banks and credit unions allow their customers to safely park money with them. They profit when they take a portion of their customers’ deposited funds and invest it in one way or another. Most of the time, this involves loaning customer deposits to other individuals and businesses in return for interest.
Banks and credit unions can also invest those funds in the securities markets. Larger banks typically invest millions, if not billions of dollars of their customers’ money, although federal regulations limit the amount of bank deposits that can be invested in aggressive securities like stocks. These organizations tend to place highly educated and experienced professionals in charge of these investments.
Insurance companies
Similar to banks and credit unions, insurance companies invest company money (mostly from insurance premiums) and their customers’ funds in the securities markets. Insurance companies must always have a significant amount of money at their disposal to ensure claims can be satisfied, and many tend to keep large portions of capital invested in safer, short-term securities (e.g. money markets like Treasury bills). There are also many insurance products (e.g. annuities) that have features requiring an investment in the securities markets, including the stock market.
Insurance companies, like all previous examples, place financial professionals in charge of these pooled investments.
Investment advisers
We already discussed investment advisers
in a previous chapter, and they too can be considered institutional investors. Many investment advisers operate using omnibus accounts, which involve combining all their clients’ assets into one single account. This allows the adviser to operate as a single entity when trading on behalf of their clients, giving them leverage in the markets (don’t worry about the specifics). Again, another example of a financial professional investing a pool of money on behalf of others.
While some retail investors are educated, sophisticated, and understand market dynamics, this is not true of the majority. Because many don’t have significant resources at their disposal (in terms of capital, knowledge, experience, market data, legal expertise, etc.), most retail investors are inherently at a disadvantage when interacting with financial professionals and larger investors (like institutions). That’s why securities laws and regulations prioritize protecting them. When a retail investor engages a financial professional, there’s almost always some form of government supervision involved.
On the other hand, institutional investors are largely sophisticated, extremely knowledgeable, and have immense leverage in the market. The Uniform Securities Act (USA) does not enforce many regulations on financial professionals when dealing with institutional investors, meaning there’s less government supervision for registered persons when only engaging institutional investors. This results in less protection for these investors, but do they really need it? Remember, these are large pools of professionally managed and invested assets, and the financial professionals overseeing those funds have access to significant resources.
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