Direction Choices
ANALYSIS

Investors need to rethink operating model

A neat little story of investment flows, asset allocation changes, and relationship and service demands is emerging from the third annual www.top1000funds.com/Casey Quirk Global Fiduciary CIO Survey. If you’re a CIO of an asset owner what that means is more control but also more responsibilities and the demands of more internal resources. For managers it means changing your proposition for a more customised approach.

The third annual www.top1000funds.com/Casey Quirk Global Fiduciary CIO Sentiment Survey seeks to measure the sentiment of asset owner investment teams around the world.

Conducted with the expertise of the financial services management consultant, Casey Quirk,  www.top1000funds.com, the 2014 survey looked at the changes in asset owner structures and investments, and specifically measures the behaviour of internal investment teams, their outlooks and corresponding asset allocations.

The survey included responses from more than 110 investors, from a wide range of participants including pension funds, sovereign wealth funds, insurance companies, endowments and foundations, with a combined assets of $2.1 trillion.

The overwhelming trend emerging from the survey is that investors are shifting in two ways. There is a broad divergence in risk on versus risk-off investing, driven largely by the investor’s investment objectives and how far they are from meeting those objectives. Secondly there are changes in how asset owners are building portfolios ranging from full investment outsourcing to significant investments insourcing.

The combination of these two dimensions means many asset owners will need to rethink their operating model to appropriately resource and govern the investment engine and many investment managers will need to tailor their client engagement model to reflect diverging preferences.

One of the key findings of the survey is that risk and return objectives are being driven by unique outcomes.

Across all respondents, 59 per cent of investors have an absolute return target which is up from 42 per cent the year before.

The funded status among pension funds is creating a divergence in risk appetite. The best funded plans are reducing their international and high-yield exposure, and anticipate a large shift into domestic and non-domestic fixed income.

Tyler Cloherty senior manager at Casey Quirk says there is a push towards absolute return metrics, with more institutions pushing an outcome-oriented approach.

There is a pretty significant de-risking among the better funded plans, which is having an impact on asset allocation. When this is explored further, there is a difference in the activities of pension plans according to type.

“The better funded plans are corporates, and they are de-risking and moving towards LDI. But the public pension funds are pushing towards more aggressive assets,” Cloherty says.

Within the aggressive assets, alternatives usage is beginning to bifurcate by channel and objectives, with the de-risking corporates increasing fixed income and real assets, and public plans increasing alternatives at the expense of equities, with a projected increase in alternatives of 3.1 per cent by 2017.

Among the investors surveyed, in-sourcing continues to rise due to cost and control benefits. In particular the larger funds are planning more in-house management of investments. Around 36 per cent of assets for large funds are now managed internally, and 60 per cent of respondents plan to increase this. The largest shift in insourcing is in core equity and fixed income.

In 2014 respondents showed that around 40 per cent of fixed income assets are managed in-house, up from 22 per cent in 2013. In domestic equity around 23 per cent of assets were managed in-house, up from 9 per cent.

“Insourcing continues across plans of all types,” Cloherty says. “The downstream impacts on CIOs of this will be around staffing, internal operations, investments whether active or passive. All of this will have an impact on career risk. It’s hard to find the talent, and an easier route might be to use a third party.”

The use of passive management is heaviest among in-house managers, which is also effecting the huge dispersion in costs between external and internal mandate costs.

In 2013 the difference between external and internal costs was 46.3 basis points for external versus 7.1 per cent for internal, a difference of about 6.5 times.

This difference has doubled to 13 times, caused by the reduced cost of more internal management coupled with more alternatives being managed externally. The 2014 average costs were 53.4 basis points for external mandates and 5 basis points for internal.

Partner at Casey Quirk, Jeff Levi says the further spread of fees is due to the growth in alternatives and more esoteric asset classes, where there is less fee pressure.

“With the alpha and beta separation and more passive management of core assets in-house, there is a story of polarisation of where investors are willing to spend on alpha,” he says.

“This has huge implications for managers to alter their capabilities.”

Interestingly while cost is a driver for investors to bring assets in-house, it was control of assets that was the number one reason for insourcing.

“With the increased focus on risk and absolute return investors don’t always have complete transparency especially in unconstrained strategies. By bringing assets in-house they have more understanding of, and control around, what they are managing,” Cloherty says.

The in-house trend is not without nuance. Casey Quirk identified that a bifurcation of in-house capabilities is creating new institutional segments, and identified four types of investors.

The “in-house investor” where on average 44 per cent of assets were managed internally with internal staffing of 15. These investors conducted investment and manager screening in-house and used co-investment as well as direct investment for alternatives.

The “sophisticated investor” that had in-house manager selection capability and used consultants selectively. On average they had 9 per cent of assets managed in-house and a team of around 6 split between investment and research.

The other two types of investors were the “mainstream investor” which was consultant driven and used traditional products and asset allocation, and an “outsourced investor” which third parties having investment discretion. Both of these types of investors didn’t manage money in-house.

As the dynamics in the industry change, the survey finds chief investment officers will need to manage a growing array of investment methods, from co-investment to in-house management, to execute on their allocation guidelines.

Casey Quirk predicts that in the future, asset owners will measure the success of their in-house asset management capabilities, not by business profitability, but by the cost savings against external mandates and by their ability to meet cash-flow objectives.

Meanwhile, external parties, including managers and consultants will be expected to provide growing customisation and knowledge sharing.

The survey found that investors consistently valued deep knowledge of investment strategies as the most important trait in a manager, followed by access to investment professionals.

“A lot of consultants are being forced to rethink their business model as many asset owners diverge in their investments approach: either more in-house discretion where consultants provide input and data or a more outsourced model where consultants may be asked to act as a fiduciary.” Levi says. “There are also big implications for managers, as each investor group wants different products and research focus. Managers need to plan and think about out how to service the different groups, whether the service they are giving is too technical or not technical enough, this could lead to a lot of challenges.”

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