Want to know what category of investor you are? Proactive is here to break it down for you.
In this article:
- A brief definition … or all you need to know in a few paragraphs
- The retail detail … or who are you calling unsophisticated?
- How sophisticated are you ... or just pulling the yacht in now, I’ll be with you momentarily
- The big end of town … or we are the management
- Sophisticated and institutional vs retail …it’s also like Superman vs Batman
- Buyer beware
Your level of experience and assets usually determines the type of investor you are, so let’s quickly define the four types of investors listed above.
A brief definition … or all you need to know in a few paragraphs
If you are time-poor, or just can’t be bothered reading a 1000-word article about the types of investors, here are the cliff notes…
Professional investor:
- Hold an Australian Financial Services License (AFSL); or
- Have or control gross assets of at least $10 million.
Sophisticated investor
- Have gross personal income over the last two years of at least $250,000; or
- Have net assets totalling more than $2.5 million.
Institutional investor
- An organisation purposed to invest its own assets or those it holds in trust for others; and
- Includes fund managers, superannuation/pension funds (industry, government or corporate), life companies, universities, banks, etc.
Retail investor
- Any investors that are not institutional investors, or pretty much anyone who doesn’t have an income of $250,000 or $2.5 million in assets;
- Those who buy and sell debt, equity, or other investments through a broker, bank, real estate agent, and so on; and
- Retail investors manage their own money.
There you have it; you can stop reading now.
But wait. There’s more.
Let’s go deeper.
The retail detail … or who are you calling unsophisticated?
Retail investors, sometimes known as mum and dad investors, are investors who buy and sell debt, equity or other investments through a broker but only have small purchasing power.
They are not considered high net worth investors.
The retail investor is generally thought of as less educated than sophisticated or institutional investors, however as we have seen recently, the retail investor can have a powerful influence on the market.
Looking at you, Reddit retail investors who spiked GameStop.
The truth is, retail investors are becoming savvier and savvier about the market through the myriad trading apps that are now available for anyone to use, through social networks and through their own desire to learn about market drivers.
Traditionally, retail investors invest smaller amounts of money and execute their trades through online brokerage firms or other types of investment accounts.
They buy and sell securities or funds with a basket of securities, such as mutual funds and exchange-traded funds (ETFs).
Smaller trades mean smaller purchasing power, which leads to generally higher fees and commissions. However, the advent of apps such as Superhero have lessened the cost for retail investors to trade.
Retail investors are often accused of lacking the knowledge to trade successfully and are encouraged to seek professional financial advice and trade through a broker.
It is said, the retail investor is influenced by behavioural biases and engages in panic buying and selling, which can have an adverse effect on markets.
As stated, the tide is turning and many retail investors would call BS on that maxim, but caution is still paramount.
How sophisticated are you ... or just pulling the yacht in now, I’ll be with you momentarily
A sophisticated investor is a classification of investor. It classifies someone as having enough wealth or assets to participate in more advanced types of investment opportunities.
These are generally high net worth individuals with broad experience in financial markets.
The definition of a sophisticated investor varies based on country or circumstance. In Australia, a sophisticated investor must have a certificate from a qualified accountant confirming they have a prescribed net asset or gross income level.
The certificate exempts them under the Corporations Act 2001, so they can buy financial products without a regulated disclosure document such as a prospectus or product disclosure statement.
A person holding a certificate is a:
- ‘Sophisticated investor’ for the purposes of Chapter 6D (if offered debt or shares); or
- ‘Wholesale client’ for the purposes of Chapter 7 (if offered a financial product, other than insurance, superannuation or a retirement savings account product or service) and the financial product is not used in connection with a business.
Eligibility for a certificate:
- A gross income of $250,000 or more per year in each of the previous two years; or
- Net assets of at least $2.5 million (reg 6D.2.03 and reg 7.1.28).
Due to their net worth and higher-income bracket, a sophisticated investor is eligible for investment opportunities that are out of the retail investor’s reach, including pre-IPO securities and, in some cases, hedge funds.
It should be said though, that a sophisticated investor can still lose money on the market despite their experience, while the regulatory safety net that prevents retail investors from high-risk opportunities is removed.
The big end of town … or we are the management
And then there were the institutional investors.
These are companies or organisations that invest money on behalf of clients and may include endowment funds, commercial banks, mutual funds, hedge funds, pension funds, and insurance companies.
Again, these are sophisticated investors, but they have the resources and specialised knowledge to extensively research a wide range of investment opportunities.
Institutional investors generally buy and sell large positions in stocks, bonds and other securities and can move the market through demand and supply forces.
They can also be defined by a large number of transactions on major exchanges.
Interestingly, institutional investors make up more than 85% of the trade volume on the New York Stock Exchange.
Due to their size, institutional investors can generate better fees on their investments.
Sophisticated and institutional vs retail … it’s like Superman vs Batman
Here’s the difference between institutional and individual investors:
There’s a problem though. The lines are blurring. Where the sophisticated and institutional investors have always had more power (and this remains so for institutions, the differences between sophisticated and retail investors are narrowing.
Today, the number of Australians who meet the sophisticated investor test increased from 1.9% of the population in 2002 to over 16%.
That is more than three million retail investors who are now exposed to riskier investments.
Australian National University associate professor Ben Phillips found 1.09 million households (or 3.25 million individuals) meet the legal definition ($2.5 million in assets or annual income exceeding $250,000) for a sophisticated or wholesale investor.
AFR wealth editor Aleks Vlkovich wrote recently: “Applying Reserve Bank of Australia and Treasury income and asset price assumptions, the number of sophisticated investors could reach 29.1% or 6.78 million adults by 2031 and 43.6% or 11.5 million adults by 2041, according to the ANU research, which was commissioned by fund manager Coolabah Capital and seen by The Australian Financial Review.
“Even moderately stronger than expected wage growth could see that number balloon out to almost half of households (49%) over the next 20 years.
“Under the law, consumers who meet the yardstick can access risky and complex investments usually reserved for big institutional investors and off-limits to regular, retail punters.
“But crucially, they also forgo protections against inappropriate advice and conflicted remuneration accepted by advisers. Product providers limiting their audience to wholesale investors have fewer disclosure requirements.”
According to Dr Phillips, “Clearly the share of Australians earning $250,000 in gross income over two consecutive years, or those with more than $2.5 million in net assets, has changed dramatically over the last two decades because of income and asset price inflation.”
“These changes arise as a result of the failure of the legislation to index the ... wealth tests in the Corporations Act’s sophisticated investor definition ... to the increase in both income and wealth over the 20 years since the definition was introduced.”
Clearly, the net wealth test should be raised or indexed.
Buyer beware … or seek professional financial advice
There you go. Now you know the difference between the different investor classes.
If you are a retail investor who suddenly finds that bracket creep has turned you into a sophisticated investor, then take care to do your due diligence before investing.
The same goes for any investor class really.
Investing is volatile. Individual investors may not be able to hedge against the volatility as well as an institution.
Seek advice. Do your own research. Don’t jump blindly into a stock or invest on emotion and invest with care.