Size matters in institutional investing, but how exactly does it result in better returns? Research by CEM Benchmarking shows large, internalised, active investors produce more net value added than small, externalised, passive investors. When private equity and unlisted real estate are included into the analysis, internalisation of asset management becomes a significant predictor of value add.
Analysis of Toronto-based data insights group CEM Benchmarking’s database of large asset owner costs and performance data, shows that the largest institutional investors do add incremental value over and above smaller funds. Net of costs, funds with more than $10 billion in assets under management have consistently delivered excess returns that are significantly higher than smaller funds with under $1 billion in assets under management.
“The larger the funds are the more consistent outperformance on a both a gross and net basis you will find,” said Rashay Jethalal, chief executive of CEM Benchmarking speaking in a presentation hosted by Canadian Club Toronto accompanying publication of the report. “Scale really matters.”
The research found that large funds have been able to achieve these positive results while taking on less active risk than smaller funds. The advantages of scale most prominently manifest in these investors’ ability to implement private assets internally, resulting in much lower overall private asset management costs.
Net of costs, the largest institutional investors deliver more value added than smaller funds in both public and private markets, an advantage driven almost entirely by lower staffing per dollar invested and lower fees paid to external managers. On average, smaller funds delivered 47 basis points of outperformance before costs, 36 basis points lower than the 83 basis points of outperformance delivered by funds with more than $10 billion assets under management.
Typified by the successes of the large Canadian funds, there is an increasing belief within the investment community on the benefits of scale in asset management.
In the Netherlands, the pursuit of economies of scale by defined benefit pension funds has been underway for more than 20 years. In 1997 in that country there were 1,060 defined benefit pension funds. By 2015, consolidation had reduced the number of Dutch pension funds to 290.
In the UK, over 90 previously stand-alone local government pension schemes are merging into eight larger asset pools.
Nor is the trend unique to defined benefit as evidenced by the rampant merger activity with the Australian superannuation funds.
The CEM research focuses on value added, the difference between a fund’s policy benchmark and the actual return realised by the fund.
Value added is the sum of both manager value added within asset classes and tactical portfolio decisions between asset classes. Value added has the advantage of being relatively agnostic to asset mix, enabling comparisons across funds.
One possible explanation for larger funds’ outperformance is that the largest funds are taking on more active risk than smaller funds. However, the research shows this not the case – not only are larger funds generating higher value add, but they appear to be doing so while taking a lower level of active risk – or as likely, diversifying away more of their active risk.
This observation is especially important considering the almost complete lack of persistence observed in value add. Put another way, much of the variability in value added can be attributed to randomness rather than skill.
Prior research conducted by CEM Benchmarking has shown that the most important quantitative features of funds for determining value added are active management, internalisation and economies of scale. Private equity and unlisted real estate are large contributors to gross value added at the fund level and reflecting their higher allocations to private equity and unlisted real estate, more of the gross value added realised from these asset classes accrue to large investors. While it would be easy to suggest that smaller funds should simply invest a higher proportion of their fund in private assets, one cannot ignore the impact of costs.
“There is a small list of things that improve returns but don’t involve taking more risk,” Bert Clark, president and chief executive officer of IMCO says. “There is a free lunch of diversification and building a better portfolio; costs are also a free lunch – get your costs down you will have better returns. Sadly a lot of risk-free, return-enhancing strategies are only open to bigger investors.”
Moreover, the economies of scale advantage of large investors in public markets is also driven by cost advantages and not skill differences. The research found that as assets under management increases efficiencies in public markets are found which improve the bottom line by approximately half, if not more. Economies of scale are found in investment costs for external managers as well.
For example, total investment costs for externally managed active US small cap equity portfolios increases slower than assets under management. Where an external $200 million portfolio of active small cap. US stock is expected to cost 55 basis points, a $2 billion portfolio is expected to cost only 40 basis points.
For public market assets the data is clear; as you get bigger, costs increase slower than AUM which translates directly into improved net value added, even excluding the impact of private market assets.
Large, internalised, active investors produce more net value added than small, externalised, passive investors. When private equity and unlisted real estate are included into the analysis, internalisation of asset management becomes a significant predictor of value add; internalising private equity and unlisted real estate improves net performance.
While internally managed portfolios of private equity and unlisted real estate perform marginally worse than external investments gross of costs, the cost savings, measuring in the 100s of basis points, far outweighs any difference in top line return. Investment costs alone may not be the only cost benefit of internalising private equity and real estate. A second advantage that can be gained by internalising private equity and real estate is the ability to exert control over the use of leverage.
Returns in private equity or unlisted real estate are usually amplified with leverage, either through subscription lines of credit or portfolio company bond issuance in the case of private equity, or through mortgages or capital structures financed with debt in the case of real estate.
Large Canadian funds such as CDPQ, CPPIB, HOOPP, OMERS and OTPP all issue debt and participate in repo markets at significantly lower rates than are available to real estate funds or private companies. Doing so however requires scale.
Successfully internalising private equity and/or unlisted real estate demands scale. While smaller investors have some internally managed real estate, the asset base is usually low, and the performance tends to trail those of larger funds.
“It’s not easy to access private investments, typically people invest through funds – certainly smaller investors. The fees you pay to invest in a fund may well eat up all the benefits of being in that asset class. Scale typically allows you to get the fees down, and co-invest alongside in select transactions,” IMCO’s Clark says.
Bringing private equity assets inhouse is an activity limited to the largest funds – the smallest investor in the CEM database that reported having substantial internal private equity investments in 2020 had $18 billion in total assets, while the average investor with internal private equity investments in 2020 has total fund AUM of $152 billion.
This is the real win for scale, the ability to deliver cost-effective and diversified private asset management by leveraging scale to implement these assets internally.