Organisational Design

What is the minimum AUM for internal management?

Large funds outperform small funds mostly mainly due to the cost savings of internal management. So when does internal management make economic sense for a fund? It’s at a much lower AUM than you might think.

CEM Benchmarking analysed a universe of 186 pension funds globally. That universe is split into four groupings: 77 funds with an average of £1 billion, 56 with an average of £10 billion, 30 with an average of £20 billion and 23 with an average of £50 billion.

The analysis of these various cohorts reveals a large difference in the costs, with the £1 billion funds total costs at 25 basis points more than funds with £50 billion in assets.  The difference – 69 basis points versus 44 basis points – is due to a large degree to the level of internal management.

John Simmonds, principal at CEM says that the difference between the investment costs of small and large funds goes straight to the bottom line return.  He puts the cost differences down to three factors .

“One third of the saving comes from having more internal management but paying less for external management and using less fund-of-funds are also important” he says.

“The larger you get the more money you can save using internal management and by going from fund of funds to limited partnerships or even direct deal making in private markets. The reason large funds typically outperform smaller funds is cost.”

In private equity, for example funds with £1 billion paid 384 basis points where funds with £50 billion paid 215 basis points. The difference is largely due to the type of vehicle, with 61 per cent of funds with £1 billion accessing private equity through fund of funds. Less than 8 per cent of funds with £50 billion use private equity fund of funds.

One of the implications of this is that small funds need to look at asset allocation and implementation techniques very differently to large funds.

“Small funds are often accessing private markets through expensive structures,” Simmonds says.

Small funds are copying large funds, but they don’t have the resources or scale to implement at a reasonable cost.  “Don’t copy the large funds unless you are sure you can invest cost effectively,” Simmonds says.

The data shows that on average, internal management beats external management due to cost, so the natural next question is ‘when does internal management make sense’?  Many funds have been grappling with this question.  Of course there are many considerations for managing money internally, but the economic rationale is one that funds should consider closely.

CEM suggests that internal management is justified economically at surprisingly low size thresholds.

“When does internal management make economic sense, it’s lower than we anticipated,” Simmonds says.

CEM looked at whether there was a rule of thumb, or criteria, for a minimum size for internal management.

On average, those funds that have internal management employ one front office full time employee (FTE) for every £0.5 billion in public equity.

“We worked on the hypothesis that, getting started, you would want at least three front office FTE to mitigate some of the key-man risks,” Simmonds says.

For every front office FTE, CEM’s data reveals that funds need a further two in the back office.  That makes a minimum of nine FTEs – three in the front office and six in the back office.

According to CEM, the global average all in cost, including all overheads, of each full time employee is £250,000. That equates to a total budget of approximately £2.25 million to get started.

“An average cost for active external management across all public equity asset classes is around 50 bps” explains Simmonds.  At £1 billion invested in public equity that equates to fees of £5 million.  Simmonds explains that the actual ‘crossover’ point, when it makes economic sense to build an internal team is therefore around £0.5 billion for public equities.  For fixed income the minimum size is closer to £1 billion.

“Of course, the fact that it makes economic sense at that point doesn’t mean that every fund of that size should do so.  There are a host of factors that need to be considered alongside cost,” Simmonds says. “At least we now know the starting point for having the conversation.”



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