Access the Importance of Institutional Investors for Financial Market - Term Paper Example

RUNNING HEAD: Importance of al investors Assess the importance of al investors for financial market of Subject Name of Professor Date 1. Introduction This paper seeks to assess the importance of institutional investors for financial market. This will look into nature of institutional investors, how they have contributed to the growth of economies and their links to cause the proper functioning of the financial markets. 2.1. Who are the institutional investors? Institutional investors are entities with large amount to invest. They would include insurance companies, pension funds, mutual funds, investment banks and endowment funds. These investors have been prominently present in Anglo-Saxon countries for a long time. Their presence and importance can be observed to have increased intensely in Continental Europe, especially since the second half of the nineties. An increase in the amount of funds that these type of investors became especially prominent in 1990s. Concurrently, institutional investors in Continental Europe on average showed a larger craving for investments in the stocks of listed companies during the last two quarter of the nineties. Usually, institutional investors are considered are observed to create or influence a constructive effect in the stock prices of the firms in which they invest. These investors are claimed to cause reduction in information asymmetries between investors other than existing shareholders and company. Their contribution to greater liquidity of the company’s stock was also noted. Furthermore, improvement in corporate governance was also asserted (Huyghebaert and Van Van Hulle, 2004). Nevertheless, there are negative consequences from the existence of the institutional investors. One claim is the increased variability in stock prices. Another claimed drawback is conflicts that can occur between individual or non-institutional investors and these institutional investors (Huyghebaert and Van Van Hulle, 2004). 2.2 What is the role of different kinds of investors in the financial markets? Financial markets are the instrument to have savings from those who did not consume every income they earned and to transferring them for effective use. This would eventually lead to creating financial assets or claims such as stock and bond instruments (Mayo, 2007) It can thus be argued that if financial market is meant to transfer savings to productive uses, the role of institutional investors would for the effective operation of the former. Institutional investors should be deemed to promote the operation of the financial markets. As the former would represent buyers and sellers of securities in large quantities they could ensure the effective operation of law of the supply and demand in the market. They could be deemed to cause efficient function by having them as competing players in the demand and supply of investment options. The economic requirement however is that there should big number of institutional investors so as not to create a monopoly or oligopoly that could create situation where they could sabotage the economy in preventing economies of scale and not attaining the allocative efficiency (Weisbrod, et al, 1978). There could be inefficacies created by big mergers as could found in experiences of big companies in the defense industry in the United States (Sandler & Hartley, 1999) as facilitated by big institutional investors. Savers in the economy can transfer their funds to would-users under two basic methods. They are the direct transfer and indirect transfer, under direct investment, one can just start ones business by putting up a sole a proprietorship or join other persons through partnerships and by investing funds as owners, direct transfer is effectively made. The savings are converted into investments and from an economic view point the purpose is generate more wealth from the savings since there is opportunity cost of money. The same direct transfer can also deemed to have occurred if corporations make initial public offerings and investors are correspondingly issue certificates of stocks or securities in the primary market direct transfer also occurs when securities are initially sold to investors in the “primary” market. The moment these securities are created from the primary issuers, it is now possible to subsequently buy and sell or trade through the secondary market. Thus the financial market is designed to serve also the purpose of creating markets in existing securities. The secondary markets should be observed that they do not transfer funds to the users of funds. What they transfer is ownership of securities among different investors. Sellers would be more than will to trade their securities for cash. Similarly buyers would be interested to trade cash for their securities. The trading under the secondary markets is normally done through the stock exchanges in many major cities of the world. 2.3 Institutional Investors and their importance to the financial markets The institutional investors allow the effective functioning of the financial markets. That the financial markets of OECD countries are believed to be functioning well is supported with facts. Financial markets are better appreciated in these countries compared to developing ones. The large amount of financial resources controlled of institutional investors and together with equity investment in listed firms is found to be growing in all OECD-countries over the period 1991-2001. Using the market value of total assets held by institutional investor as a percentage of the country’s GDP and the value of shares invested by the same institutional investor in the capital market as a percentage of total assets of same institutional investors, there is basis to support the claim on the significant role of institutional investors not only in the financial markets but also in the growth of the economy (Huyghebaert and Van Van Hulle, 2004). Institutional investors as a group manage very important amounts of capital, ranging from a capital stock equal to more than 80% of GDP in Germany to more than 190% in the United Kingdom and United States in 2001. Such fact of institutional investors holding a significant position was mainly attributed to the pension system. It is claimed that the active population of these countries generate the pensions of the retired and that Anglo-Saxon countries also have established a capitalization system, with individuals saving for their own pensions. Since the financial reserves that are produced pensions are in the hands professional investors as managers, this would make institutional investors as necessary part of the financial markets and the economic system (Huyghebaert and Van Van Hulle, 2004). 2.3.1 Institutional investors reduces information asymmetries and lowers cost of capital Asymmetric information is noted to result to price discounts in a transaction in favor of those who have more information. Using car market as an example Akerlof demonstrated that rational buyers appreciate that they have a less advantageous position as compared to sellers that are well informed about the essential quality of the of cars offered for sale. To have more information for decision making would have the effect of reducing the risk and therefore cost of capital must be deemed reduced. Between institutional investors and non-institutional one information is asymmetric information is better reduce with former. Would-be investors of companies that have issued to institutional investors are expected to have better information and this would translate to a lower cost of capital for purposes of conducting valuation on the stocks of companies. The logical consequence is therefore to choosing investing in reducing information asymmetries if the plan is to have increased stock prices (Huyghebaert and Van Hulle, 2004 citing Akerlof, 1970). It is common for institutional investors to provide a form of risk fooling for a number of small investors (Davis and Steil, 2004). Even from this point there is diversification (Davis and Steil, 2004) that could reduce risk and could reduce cost of capital as next consequence. To reduce information asymmetries is indeed logically connected to enhancing efficiency of the financial markets with having more investors to more access to information. It is usual that institutional investors are present in listed companies than in private companies or those companies whose stocks are not listed. Listed companies have their annual reports available to the public compared with lack of requirement for the non-listed. Even on this note, it should be easy to have better access to financial information as result also of the influenced from institutional investor. Thus the claim that institutional investors would reduce information asymmetries could be validly sustained as institutional investor represent existence of well managed finance portfolio of investments in the economy. To illustrate, insurance companies are to earn a continuous return from safer than risky investments from a big part of its available funds for investment are required by existing laws in order to assure their subscribers on the liquidity and solvency these insurance companies at practically all times. Thus the legal requirement for these companies or institutional investors to have trust funds invested in less risky investments is force that in effect, drives them to become institutional investors. In other words, institutional investors get created by economic forces and legal requirements in their need to survive, to grow and be sustainable profitable. This should explain the interest of the government to sustain the operation of insurance companies if something goes wrong in the economy. This was seen in the decision of the US government to bail out AIG (Corporation Essvale, Essvale Corporation Limited 2010) while allowing Lehman Brothers to go bankruptcy (Wroe & Herbert, 2009). 2.3.2 Institutional Investors results to better liquidity Better information that comes with reduced information asymmetries also lead to better liquidity as well since institutional investors are attracted. The fact the institutional investor would favor better transparency; the effect is also increased liquidity. This must easily be appreciated on the mere fact the diversity of owners in a corporation indicates ease of disposing shares of stocks since normally institutional investors would choose listed companies rather those that are not listed because of the better information in the former kind of companies (Huyghebaert and Van Van Hulle, 2004 citing Akerof, 1970). 2.3.3 The growth of institutional investors comes with better corporate governance and growth of economies Better corporate governance can be seen in greater sustainability of the long-term growth of companies. Companies are mean to live a long and sustainable life as they try to recover investment over a long and sustainable period. The fact that the economic growth of countries were supported by investments by the private sector which is mainly made possible by private companies largely financed by institutional investors would point the great contribution of the latter in sustaining the economies. Sustaining economies must therefore be deemed being obviously favourable to the stock market or financial market. At the same time institutional investors must be deemed promoting corporate governance in the operations of companies in Anglo-Saxon countries Europe and Japan. Data indicated that the growth of institutional investors in these countries has occurred in the context of rapid growth in financing in their economies (Huyghebaert and Van Van Hulle, 2004). This would therefore strengthen the claim that institutional investors benefit the financial market because it benefited the economy. 2.4 Will leaving alone the institutional investors completely beneficial to the financial markets? The answer to the question in the negative since doing so could leave the possible evils of monopoly or oligopoly as differentiated from the perfect competition or just having more active market competitors to allow market forces to operate. There are legal requirements to maintain the rules of game fair and this should not allowing the concentration of forces to only one or only few players. To allow the first would to consent to monopoly and consent to the second is to allow oligopoly (Arnold, 2008; Slavin, 1996). Both situations would be anti-thesis to the operation of the law and supply demand which best illustrates allowing the market forces to determine the production of goods and services in the market. 3. Conclusion This paper has found how important to have institutional investors to the financial market. One is in reducing information asymmetries and resulting reduction in cost of capital. To reduce information asymmetry is to allow the more efficient operation of the financial markets. The essence of the operation of free market is to allow for allocative efficiency which would be beneficial to the company. If such as the case the presence of institutional investors is helping the attainment of the purpose of financial markets. The other is provision of liquidity which the said institutional investors can help insure. Still another is the promotion of corporate governance that would sustain the companies’ growth over the long-term. The operation of the financial market is just one part of the economic policy of allowing the market force forces to operate. Allowing the market forces would mean allowing the players to determine them the goods and products to be produced as contrasted to a command economy where the government which will tell what will be produced. The presence of institutional investors is a necessary consequence of allowing market forces to operate since these investors would act as demanders and suppliers of funds of at the same time. These institutional investors came into being as such because of their need to continuously earn good returns to least equal their opportunity cost or cost of capital which is assumed to always exist in a capitalist economic system. Thus institutional investors are deemed to have their roles to play in the efficient operation of the financial market which assumed to act as conduit in bring savings from the hands to savers to those who would need the same as motivated to look for sources of capital at minimum cost with the purpose of these companies to attain their wealth maximization objectives. However, allowing the market forces may mean giving freedom for institutional investors to come about but there are still limits to what companies can do. Monopoly or oligopoly should be prevented as much as possible to allow institutional investors to become effective players of industries in the economy. 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