It comes as no surprise that institutions charged with managing the investments of others – mutual funds, pension funds, hedge funds and endowments for example – would themselves invest in stocks and other financial instruments. Because these organizations have their own experts who are well-versed in research and analysis, their choices carry extra weight with the investing public. It follows that the larger the institution, the heavier the weight of influence.
A stock's float, i.e., those shares available for public purchase and sale, may enjoy robust value when an institution purchases but may also plummet when the same organization decides to sell. Outsized influence can lead to greater unpredictability.
Like a Sugar High
The initial attention that a large institution accords a stock is a short-term thrill indeed. First of all, the price tends to rise at such a purchase. In addition, the institution will make more buys if the stock price peaks and then declines in order to shore up the investment. Others taking a percentage of the float take confidence that an army of proficient number crunchers are behind the institutional decision-making, even more so when multiple institutions get aboard.
Individual investors often look for guidance in who, or what, is looking at the same shares and often follow suit. Yet, like an energy rush that comes from something sweet, a crash may lurk beyond the optimism.
The Almost Inevitable Sell
Institutional investors have all kinds of tools with which to promote the stocks they buy and own, especially when their float position is large. They employ communications media like radio, TV and Internet ads as well as their presence at investor meetings. Knowing this, retail investors watch institutional buys closely so as to act before the stock price gets too high. When the percentage of float held by institutions is high, those funds can exercise tremendous sway over the company, including making executive personnel "suggestions."
There are occasions when institutional ownership exceeds the total float because the funds have bought up the borrowed shares held by short sellers. When it becomes impossible to acquire any more shares, the stock almost inevitably begins to decline. As often and intensely as institutions promote the value of the stock, the cessation in purchasing sends a powerful signal that the share price has hit a ceiling. At this stage, analysts may downgrade the stock because its price potential has been exhausted.
What Happens When Institutions Sell?
Although institutions claim to be on the same page with individual investors, their actions have a greater impact because of the number of shares they hold. When they sell, a sell-off follows. The sale of large aggregations of securities leads to a steep drop in share value because the market cannot absorb all the shares as fast as the institutions can dump them. While this drop cannot be pinned entirely on institutional investors, it is practically impossible for the stock price to rise under these circumstances.
Institutional Investing and Proxy Fight Dangers
As noted above, large institutions that acquire proportionally large percentages of the float are prone to use their equity to affect company decisions. One of the ways in which they do this is to gain control of seats on the board of directors by gathering a large number of proxy votes. This can create bad blood among directors and lead to intra-corporate legal battles that can have a negative effect on stock values. For these reasons, individual investors should weigh carefully whether to follow institutions in purchasing specific shares of mutual interest.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.