The allure of potentially higher net returns from portfolios precisely tailored to values, beliefs and risk appetite is hard for any asset owner to ignore, yet needs to be balanced against the many challenges associated with managing assets in-house.
To this end, it is worth outlining the key benefits that in-house asset management can offer. Several academic studies (see note 1) have shown that funds with more internal management (as a proportion of total assets) have achieved improved net returns, largely due to a significantly reduced cost-base. According to the research, this does not just apply to the more esoteric realms of private equity; these cost savings can be seen across more traditional asset classes too. In an industry where most outcomes are uncertain, any reduction in costs is compelling.
Tailoring of portfolios
While cutting costs is, in itself, persuasive, another driver of internal management is to re-take control of decision making to enable the more precise tailoring of portfolios to stakeholder objectives. Matching asset owner’s goals and philosophies with their investment decisions should result in improved, sustainable investment outcomes over the long term. When combining a series of external mandates to form a portfolio, there are inevitable imperfections, whether gaps or overlaps. This could be a duplication of investment research, cross-over of asset selection, or missed opportunities to name a few. There need not be such compromises when managing investments in-house. Furthermore, internal management can improve direct access to investment opportunities, for example, in private markets. Large funds may be able to leverage their size, credibility and “brand” to find investment opportunities that might not be available to others.
In-house asset management can provide better alignment. One of the major issues for asset owners using a largely outsourced model is the leakage that can arise from a chain of principal-agent relationships. This can result in the original intentions of the asset owner as principal being lost among the priorities of various agents as misalignments (such as different time horizons) creep in. The compounding effect of even small distorting misalignments can have far-reaching implications at the end of the investment chain and in the outcomes achieved. The impact of better alignment may be hard to substantiate quantitatively, but this does not mean that it should be overlooked.
The decision to take on internal asset management is not a simple one and the implication of doing so is significant change, particularly in terms of resourcing and risk management. Additionally, there is a question of size – is the fund big enough for in-house management to be feasible?
Choosing in-house management (to whatever degree) naturally requires a fundamental belief in its long-term benefits. But for it to be truly effective it should not only be etched into a belief system, but must flow throughout the organisation and systems. This makes good organisational design imperative. So the time and effort invested in properly establishing this framework are essential if internal management – and overall risk management – is to be successful.
While investment beliefs and organisational design can be made more tangible through audit, articulation and agreed process, culture – an element of no less importance for successful investment – remains far more difficult to pin down. In essence, culture is the mechanism for allowing values and investment beliefs to permeate an organisation’s behaviours. For internalisation to work best, this culture must encourage accountability and sound risk taking.
A shift from external mandates to internal management requires a significantly different organisational structure and resource model. Asset owners need to attract, retain and align the right talent in the competitive world of investment management, where there is a well-known international war for talent. Asset owners need to consider where their competitive advantage lies, what type of people they are best at attracting and how they might best motivate and reward them. This is a vitally important topic, and as such we will explore it further in a future article in this series. The challenge extends further than the front office too. Middle-office and back-office resources are highly specialised and should be considered alongside the appropriate infrastructure and systems.
Using in-house management brings more control but can be a less comfortable ride. Risk management is already at the top of many asset owners’ agendas but internal asset management adds layers of operational and reputational risk. It exposes them more directly to the complex and often unforgiving investment world. Having the right leadership and culture in place to manage these risks effectively is critical to the success of an internal management approach.
Asset size is often regarded as a key factor for determining whether in-house asset management is viable. It makes logical sense that the biggest asset owners are in a stronger position to take advantage of in-house management as they are able to absorb set-up costs, attract investment talent and manage infrastructure requirements. In our experience, and supported by empirical data, this approach starts becoming more attractive for funds with around US$10billion in assets under management. Smaller funds, however, need not exclude themselves from the debate, as partial internalisation is an option, in particular building strategic capabilities in-house. For larger funds the internalisation will likely extend beyond strategy to the direct management of portfolios. This could involve internalising certain asset classes ahead of others. To take this point further, the separation of the management of different asset class or elements of the investment process – such as strategy, research, asset selection and execution – could be attractive to many funds. At each point, responsibilities could be either internalised or outsourced to achieve an efficient design. Such decisions should be a function primarily of where asset owners see their competitive advantage.
There is a trend towards internal asset management among large asset owners which is hard to ignore. The internal versus external debate is complex and also context dependent. Asset owners will know themselves well, but may not be instinctively drawn to one approach or the other. As such, hybrid models of partial in-house management and partial outsourcing can offer an attractive proposition, or at least a starting point, for many asset owners wishing to raise their investment game.
1. See for example:
• “How large pension funds organise themselves: findings from a unique 19-fund survey”, MacIntosh and Scheibelhut (2012) published in the Rotman International Journal of Pension Management.
• “Principles and policies for in-house asset management”, Clark and Monk (2012)
Carole Judd is director of investment organisational change at Towers Watson