Why Do Institutional Investors Invest In Funds Instead Of Building In-House Teams

The term institutional investor is usually used in the context of the degree of influence on the market and its pricing. For example, there is often a saying that the price, under pressure from institutional investors, rolled back to a certain level in financial news. So what kind of beast is this - an institutional investor? Let's figure it out.

Let's start right away with the definition. Institutional investors are such organizations (legal entities) that accumulate the funds of numerous depositors (among which there may be both individuals - private investors and other legal entities) to invest in various financial instruments and make a profit from this process.

In the United States, there is such a thing as a qualified institutional investor. Institutional investors who manage more than $100 million and have received the right to participate in operations on the stock market without registering traded securities with the SEC are commonly referred to this category.

Institutional investors are categorized as follows:

• pension funds;
• mutual funds or collective investment funds;
• banks;
• hedge funds;
• insurance companies;
• trust funds.

American institutional investors are often called market whales because they buy and sell large blocks of securities, can move the market, and tend to know more than amateur investors. They also use highly specific software and employ an entire staff of professional analysts.

U.S. Securities and Exchange Commission publishes various reporting documents on the actions of institutional investors so that private investors can repeat their investments. Theoretically.

For example, if investments exceed 100 million USD, investors must disclose data on the SEC 13 F form.
 

Where do institutional investors invest?

The primary investment areas are company stocks, real estate, bonds, private bonds, loans, bank deposits. At the same time, there are other available ways of investing capital of an institutional investor.

With massive AUM (assets under management), institutional investors can access exceptional diversification tools. Hedge funds are the only class of institutional investors that can generate income from a wide variety of different instruments. They are allowed to do this only on the condition of restricting investors' access. Regulators suggest that hedge funds, being high-risk instruments, should be available only to professional investors.

Hedge funds are a highly effective vehicle for generating income. At the heart of a hedge fund is the manager's talent, professionalism, and experience. Without this foundation, the hedge fund will cease to be of any interest.

In addition to the tools for generating income, hedge funds, in fact, have additional tools available to protect against risks. Each manager himself develops risk management methods that are most consistent with his strategy.

As for client relations with hedge funds, there are special services on the market to ensure the transparency of HF's work. For example, MetaQuotes has a separate branch of its MetaTrader 5 platform, which is designed to run the hedge fund business. Fund clients can monitor their investments and buy additional shares directly from the MetaTrader 5 client terminal like ordinary traders.

Thus, the hedge fund investor receives a ready-made instrument with protection mechanisms.

Hedge funds are an excellent capital diversification tool for institutional investors.  According to David Friedland, president of the Hedge Fund Association, hedge funds are often less aggressive and more predictable in performance than many traditional equity investments.
 

Why do pension funds invest in hedge funds?

While pension funds are the classic low-risk investment standard, many pension funds have begun to adopt a new way of allocating funds that involve investing in hedge funds.

Many pension funds try to match assets and liabilities more accurately to avoid being underfunded in the future. Hedge funds can be used to manage, mitigate and even hedge such liability risks. Hedge funds can also reduce risks by increasing diversification from traditional holdings in the market (through owning stocks, real estate, etc.).

In addition, pension funds also have to think more about how to generate income. Rather than holding traditional portfolios of stocks, generating most of their profits from market returns, which can be easily obtained through passive index products, pension funds are increasingly rethinking their investment approach and looking for Alpha in the market.

It is estimated that up to 20% of European and American pension funds and 40% of Japanese pension funds invest in hedge funds. Despite widespread press coverage, the total amount of pension assets held for hedge funds is still small and their use is relatively cautious. The IMF and others estimate that several funds allocate more than 5-10% of total assets for these investments. More importantly, all polls around the world show that pension funds intend to increase these weights.

As it follows from the logic, the stopping moment of the increase in the proportion of hedge funds in pension funds portfolios is the lack of proper clarifications from regulators. As regulators can provide more guidance on dealing with hedge funds, an increase in investment in this class should be expected. Regulators want to encourage greater transparency in hedge funds themselves to help pension fund investors properly assess and manage risks.
 

Investing in funds Vs. having an in-house investment department

As already mentioned, hedge funds, by their definition, are a diversification tool for institutional investors. Perhaps, an institutional investor sticks to having a 100% portfolio of one single hedge fund. It sounds ridiculous in terms of building a portfolio, but it makes more sense if chosen as a well-diversified hedge fund for buying in. Remember, the key to the success of a hedge fund is a unique investing and trading strategy based on the variety of available tools.

Comparing investing in funds and building an internal investment structure falls to the comparison of costs. The cost of creating an equivalent team within the company should include all human resources and management implications that this can have on the organization.

Building an internal team entails not only high legal and regulatory costs and the need for individual risk and reporting systems but, of course, the cost of a portfolio manager, supporting analysts, and the challenge of attracting and retaining the best talent for each of these roles. This will be quite difficult to achieve for lesser-known investors.

There are also associated ongoing costs and due diligence costs incurred as a result of ongoing meetings with existing portfolio managers.

Ultimately, the institutional investor's desire to distribute funds across multiple asset classes and regions can quickly become a logistical and intellectual challenge, further multiplying the complexity and costs of efficient portfolio management.

Depending on the legal registration of the institutional investor and other related criteria, an adequately resourced in-house team can easily cost $1 million per year but is likely to exceed that amount, with no guarantees of efficiency significantly.

In other words, the institutional investor can allocate these funds to purchase hedge funds in the portfolio. The exhaust from building a large and progressive internal team is likely to be significantly worse for an investor than investing several million in a hedge fund portfolio.

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