You probably already 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 - young and old, wealthy and modest, sophisticated and novice. In today’s digital world, you can open and fund a brokerage account on your phone without ever speaking to another person. Even teenagers - who historically haven’t been very active in investing - 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 (including you and me) are retail investors. Although most securities investors are retail investors by headcount (not by trading volume), many retail investors are unsophisticated (meaning they lack significant financial knowledge) and may misunderstand how markets work.
The short squeeze of Gamestop (GME) stock is a useful example. Some smaller investors made significant profits as GME rose from roughly $20 per share in early January 2021 to roughly $480 per share later that month. However, many investors bought shares in the $200-$400 range and then watched the price fall back to about $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."
The GME short squeeze was unusual and emotionally charged, but it still illustrates a broader point: retail investors can lose substantial amounts of money, especially when trading is driven by hype and rapid price swings. Whether regulators will take action to prevent a similar situation remains to be seen (as of this writing in May 2021), but it’s reasonable to expect legal or regulatory updates.
The state administrator, along with other securities regulators like the Securities and Exchange Commission (SEC) and FINRA, is most focused on protecting retail investors.
As you work through this material, keep track of:
A common pattern you’ll see is that supervision and regulation are most extensive when retail investors are involved, while more exceptions apply when dealing with larger institutional investors (discussed next).
An institutional investor is a single entity that invests a pool of capital (money). Common examples include:
In each case, a large pool of capital is managed by financial professionals (often a team). You won’t need to memorize the operational details of each type, but a little context helps.
Mutual funds
If you’ve already prepared for the SIE, Series 6, or Series 7, you’ve seen mutual funds before. A mutual fund is a portfolio made up of shareholder money and managed by an industry professional.
For example, the Fidelity Contrafund is a fund with over $100 billion in assets and is managed by Will Danoff. Mr. Danoff is Ivy League educated (Harvard and Wharton School of Business) and has managed the fund for over 30 years. He and his team invest this portfolio on behalf of customers in return for customer fees (somewhere around $100 million annually).
While the Contrafund is a stock-based fund with moderate risk, there are thousands of mutual funds available (7,945 mutual funds existed in 2019). Each fund has its own risks, benefits, and goals. For investors who don’t have the time or knowledge to manage their own investments, mutual funds can be a practical option.
Hedge funds
Hedge funds are similar to mutual funds, but they’re generally available only to wealthier investors. They pool capital and often invest aggressively in pursuit of higher returns.
Hedge funds were widely discussed during the Gamestop (GME) short squeeze in 2021 because some 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 were once a common employee benefit. A pension is an employer-sponsored retirement plan that promises lifelong payments to retired employees who meet certain qualifications.
For example, an employer might promise to pay retired employees 70% of their highest annual earnings after 20 years of employment. If an employee’s highest annual earnings were $100,000, the employer would owe $70,000 per year (often with annual cost-of-living increases) for the rest of that person’s life.
While pension plans vary in structure and benefits, they share a key challenge: making sure the plan doesn’t run out of money (an unfunded pension liability). Employers contribute significant amounts each year, but life expectancies continue to rise. The longer retirees live, the more capital the pension fund needs to meet its obligations. That’s why employers often hire financial professionals to manage and invest pension assets. The more the fund grows, the less the employer may need to contribute in future years.
Today, pensions are rare in the corporate world, largely due to the rise of the 401(k). However, government employers (local and federal) still commonly offer pensions.
Banks & credit unions
Depository financial institutions like banks and credit unions allow customers to keep money with them. They earn profits by using a portion of deposited funds in ways that generate returns.
Most commonly, this means lending customer deposits to individuals and businesses in exchange for interest. Banks and credit unions can also invest funds in the securities markets. Larger banks may invest millions or billions of dollars, although federal regulations limit how much bank deposit money can be invested in aggressive securities like stocks. These institutions typically place highly educated and experienced professionals in charge of these investments.
Insurance companies
Like banks and credit unions, insurance companies invest company money (largely from insurance premiums) and customer funds in the securities markets.
Insurance companies must keep significant capital available to pay claims, so they often invest large portions in safer, short-term securities (e.g., money markets like Treasury bills). Many insurance products (e.g., annuities) also include features that require investing in the securities markets, including the stock market.
As with the other examples, insurance companies rely on financial professionals to manage these pooled investments.
Investment advisers
We already discussed investment advisers
in a previous chapter, and they can also be institutional investors.
Many investment advisers use omnibus accounts, which combine all clients’ assets into a single account. This lets the adviser trade as one entity on behalf of clients and can provide leverage in the markets (you don’t need the details here). The key idea is the same: a financial professional investing a pool of money for others.
Some retail investors are educated and understand market dynamics, but many are not. Because many retail investors have limited resources (capital, knowledge, experience, market data, and legal expertise), they’re often at a disadvantage when dealing with financial professionals and larger investors (like institutions). That’s why securities laws and regulations prioritize protecting retail investors. When a retail investor works with a financial professional, there’s almost always some form of government supervision.
Institutional investors, by contrast, are generally sophisticated and have substantial resources and market leverage. The Uniform Securities Act (USA) imposes fewer requirements on financial professionals when they deal only with institutional investors. That means less government supervision and fewer protections in those transactions. The reasoning is that these are large pools of professionally managed assets, overseen by professionals with significant resources.
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