An institutional fund is an investment vehicle designed for large entities like government agencies, charities, trusts, and companies. These funds pool significant capital to achieve various investment objectives, such as retirement plans or wealth creation.
Often managed by professional fund managers, these funds maintain a diversified portfolio and charge lower fees compared to retail investment products. Some common types of institutional funds include institutional mutual fund shares, institutional commingled funds, and separate accounts.
Let’s understand the institutional fund’s meaning in detail and check its various types and benefits. Also, we will learn about the various risks associated with these funds.
What are Institutional Funds?
An institutional fund is a type of mutual fund. You can think of it as a large investment pool designed for entities like:
- Pension funds
- Insurance companies
- Endowments, and
- Sovereign wealth funds
These funds manage large amounts of money and usually invest in assets that are held for a long time. They are designed to meet specific financial objectives like:
- Growing wealth or
- Funding retirement plans
It is essential to note that the prime focus of these funds is to grow investments steadily over many years rather than seeking quick profits. It is for this reason they invest in illiquid assets and have long lock-in periods. Furthermore, due to the long-term investment horizon, they offer high returns to their investors. However, these returns come with several risks such as market risk, less liquidity, and regulatory risks.
Example of Institutional Share
A classic example of an institutional fund in India is the Employees’ Provident Fund Organisation (EPFO). The EPFO manages the retirement savings of millions of Indian workers and invests in various assets to generate returns over the long term.
It is important to acknowledge that EPFO is a significant institutional investor in India. It maintains a diverse portfolio, which includes:
- Government securities
- Corporate bonds
- Equity investments
The primary goal of EPFO is to provide financial security to its members upon retirement.
Types of Institutional Funds
Investors must note that institutional funds come in various forms or types to meet different investment needs. Let’s study some of the main types:
Institutional mutual fund share
Institutional mutual fund shares are designed for large-scale investors, such as:
Pension funds
and
Endowments
Institutional shares usually have lower fees compared to regular mutual funds because they involve larger investment amounts and lower marketing costs. The main goal is to achieve steady and long-term growth while keeping risks under control.
These funds are ideal for investors who prefer a hands-off approach and are willing to trust professionals to handle the diversification and management of their investments.
Institutional commingled funds
The institutional commingled funds pool assets from multiple “institutional investors” into one collective investment vehicle. Notably, these funds are not available to the general public and are often managed by banks or investment firms.
Their primary goals are to:
- Achieve economies of scale
- Reduce costs
- Improve investment performance through professional management
These institutional funds combine resources so that their investors can access a wider range of investments and strategies that are not available to smaller investors.
Separate accounts
Separate accounts are unique investment portfolios created specifically for institutional investors. They are different from commingled funds, where several investors combine their money. Each portfolio is managed separately in separate accounts so that the investment strategy can be tailored to the investor's specific goals and needs.
It is pertinent to note that in separate accounts, investors directly own the securities in their portfolio. This direct ownership gives them more control and clarity about their investments. Furthermore, this kind of setup is perfect for institutions that want:
Personalised investment solutions
and
A higher level of customisation.
Benefits of Institutional Funds
Institutional funds are managed by experienced professionals known as fund managers. These managers use their expertise to optimise returns while managing risks. This kind of professional fund management offers significant advantages to large-scale investors. Let’s see some major benefits of institutional funds:
Diversification
These funds invest in a wide range of assets, such as stocks, bonds, real estate, and alternative investments.
Diversification helps in spreading risk across different asset classes.
It reduces the impact of poor performance from any single investment.
Lower costs
Due to the large amounts of capital invested, institutional funds usually have lower fees and expenses compared to retail investment products.
The economies of scale achieved by these funds lead to cost savings, which are passed on to investors.
Access to exclusive investments
Institutional investors often gain access to investment opportunities that are not available to individual investors.
Some common examples of these exclusive investment avenues are:
Private equity
Hedge funds
Other alternative investments
These exclusive opportunities offer higher returns to investors.
Selecting the best mutual fund schemes is often challenging. Learn how to choose the best mutual funds and achieve your financial goals.
Risks in institutional fund investment
Despite being professionally managed and investing in exclusive opportunities, institutional funds are exposed to several risks, such as market, liquidity, and credit risks. Let’s study them in detail:
Market risk
The investments made by institutional funds can fluctuate due to changes in market conditions.
There is always a high probability that economic downturns, political instability, and global events can negatively impact the performance of these funds.
Liquidity risk
Many institutional funds invest in illiquid assets such as:
Real estate
Private equity, and
Hedge funds
Usually, these investments are difficult to sell quickly without significant loss in value.
This creates liquidity risk, which is felt more during market stress when quick access to cash is required.
Credit risk
Credit risk represents the possibility that issuers of bonds or other debt instruments the fund has invested in might default on their obligations.
This risk is particularly relevant for funds heavily invested in corporate or government debt.
Interest rate risk
It is worth noting that changes in interest rates can impact the value of the fund’s investments, particularly fixed-income securities.
Generally, rising interest rates reduce the value of existing bonds.
This fall in value leads to losses for the fund.
Operational risk
This kind of risk arises from the internal processes and people managing the fund.
Sometimes funds face significant financial losses due to:
Errors
Frauds
Failures in the operational processes
Regulatory risk
It is a fact that institutional funds must comply with various regulatory requirements.
Non-compliance usually results in legal penalties and restrictions.
This increases the operational costs of the fund and impacts its performance.
Concentration risk
If an institutional fund invests a majority of its corpus in just one sector (like technology) or, say, one type of asset (like real estate), it becomes more vulnerable to adverse developments in that sector or asset class.
For example:
Say the technology sector experiences a downturn
Now, the fund could face severe losses because it has heavily invested in that area
Manager risk
It is important to note that the performance of an institutional fund is heavily dependent on the expertise and decisions of fund managers.
Some common reasons that can negatively affect the fund’s returns are:
Poor management decisions
Lack of experience
Shifts in the management team
Also read about: Different types of SIPs
Conclusion
Institutional funds are large investment pools designed for entities like pension funds, insurance companies, and endowments. Managed by professionals, these funds aim to grow investments steadily over the long term. They offer several benefits, such as diversification, lower costs, and access to exclusive investments.
Some common types of institutional funds are mutual fund shares, commingled funds, and separate accounts. These funds are crucial for achieving long-term financial objectives, such as retirement planning or accumulation of wealth. Furthermore, these funds generate higher returns. But they often come with risks, such as market fluctuations, liquidity issues, credit risk, concentration risk, and more.
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