Asset owners are increasingly looking to technology to more effectively manage complex multi-asset portfolios, enhance returns and better inform risk management decisions. Top1000funds.com looks at how technology is being used by asset owners including LACERA and REST, and the insights of BCI’s chief technology officer, Tony Payne.

Asset owners are increasingly looking to technology to more effectively manage multi-asset portfolios, enhance returns and better inform risk management decisions.

Technology allows investors to manage and draw insights from increasingly large pools of data about the companies and assets in their portfolios, gain insights into total portfolio risk exposures, and improve efficiency.

As “go anywhere” multi-asset portfolios are more common than traditional 60/40 stock and bond portfolios, technology is an enabler for investors to see through the asset classes and identify common or unintentionally overlapping risk exposures.

For the nearly C$200 billion British Columbia Management Corporation (BCI), leveraging digital technology is one of the four strategic pillars of its business plan for 2022-2024.

Tony Payne, BCI’s senior vice president, technology and innovation and chief technology officer, citing the business plan said the fund’s investment in technology has “strengthened our operational infrastructure and talent base to support more sophisticated investment strategies.”

The strategic focus is on using technology across all business functions from using new sources of data to identify and capture investment opportunities – such as in ESG – to applying technology to improve operational efficiency throughout the whole organisation.

“It is definitely an important piece of the capability puzzle,” Payne says.

As an example he says the tools and analytics have enabled BCI to apply a multidimensional analysis of ESG exposures across the whole portfolio.

He shared a “thank you” he recently received from Jennifer Coulson, senior managing director, ESG regarding a data automation project that collects company data and reviews it for quality. Coulson told Payne that the automation enabled her team to save an hour for each of the 53 companies it was collecting data on. Over a year, she estimated that would save roughly 86 workdays of her team’s time, making the team more efficient.

Jonathan Grabel, chief investment officer at the $75.6 billion Los Angeles County Employees Retirement Association, also cited the importance of tools as ESG considerations increasingly are among investors’ priorities, especially to evaluate and monitor portfolio sensitivity to the transition to a lower carbon energy world.

Grabel says LACERA “is now using its systems to calculate the carbon footprint for the portfolio over time, see threats and take a long-term view.”

In the next few years, we will be using advanced technology to generate alpha

For Andrew Lill, chief investment officer of Australia’s A$70 billion Rest superannuation fund ESG is a third lens to any investment decision.

“Technology has to be a way to cut through and determine when you have high and low sensitivity to energy transition,” Lill says.

Overall, the systems allow investors to think of the portfolio holistically, see what is happening and decide what to do about it, Lill says.

“The tools help take investment decisions out of a subjective environment that is largely based on the human experience of staff over the last two decades.”

As an example, for Australian investors accustomed to the Australian dollar being a risk-on currency and a strong tool to buffer portfolios in volatile markets, these systems help to determine if holding the currency will continue to have the same effect in a rising inflation world, Lill says.

He and others pointed to the added complexity of multi-asset portfolios and the need to ensure that institutions are not taking the same risks across public and private assets and are not taking any uncompensated risks as they continue to try to serve the plan’s 1.8 million members.

From asset allocator to investor

Grabel says that tech tools are helping his fund evolve from being an asset allocator to being an investor.

“With greater real-time access to the portfolio as a whole, asset owners can be better risk managers,” Grabel says. “In the past, asset managers’ portfolios were separate and distinct. Now we can see through on a total-portfolio basis are the exposures correct and is LACERA paying appropriate fees for those exposures?”

Robust and sophisticated risk systems are a defining factor of the Canadian Model and help set the Canadians apart and are now an increasing part of the infrastructure used by asset owners in other parts of the world. As an example, the State of Wisconsin Investment Board has been using technology to do better analytics for more complicated portfolios that are multi-asset and unconstrained.

CIO of Canada’s OPTrust James Davis has said that risk management is now as much a source of value creation as a control function and his focus is on building a portfolio that is as resilient as possible which means only allocating risk – a scarce resource – with purpose.

With greater real-time access to the portfolio as a whole, asset owners can be better risk managers

As asset owners look to the future and the uncertainty of the macro economic environment, efficiency is increasingly becoming a focus. And while declining to cite specific savings from the use of technology LACERA’s Grabel did say that the analytics help ensure the fund is getting exposures in the most efficient and liquid ways.

“Tech really does enable us to be much more intentional. In core plus fixed income, we saw that we were taking a lot of active risk for a strategy that was supposed to be risk mitigating. We moved to passive and more core,” Grabel says. When selecting managers and constructing benchmarks the tools have enabled LACERA to “construct relationships based on true alpha.”

The systems “facilitate discussions based on facts, rather than waiting until a month after (something happens) to learn about exposures from third-party managers, we have an early-warning system that allows us to be better about rebalancing,” Grabel says.

Over the last few years, LACERA has made significant investments in a comprehensive risk management platform that includes an appraisal management tool for the direct real estate investment portfolio and helped with the creation in March 2020 – as the staff went to working remotely – of a rolling 90-day cash flow report, adjusted daily, that incorporates information on all uses of cash from benefit payments to investment calls that enables the elimination of cash drag, by through a cash overlay program.

Additionally, the fund’s investment team is structured differently than it was five years ago, says Grabel. The fund now has a group called portfolio analytics that is providing the staff with internal information for risk management, portfolio analytics, strategic asset allocation and ESG and stewardship.

“It allows us better understanding of the sources of return,” says Grabel.

what is next

Funds have been using AI to gain insight into their portfolios with regard to mapping the SDGs. The consortium started by APG is the most notable – with the €600 billion European giant recently setting out the digitalisation of asset management at the core in its next five year strategic plan.

Other funds such as the UNJSPF are also conducting research on developing quantifiable SDG scores using artificial intelligence to leverage big data and systematically measure companies’ impact on the SDGs.

The C$23 billion Canadian fund OPTrust is embracing the power of AI to improve investment outcomes via two new strategies based around re-enforcement learning and uncertainty modelling.

Similarly BCI’s technology head, Payne, says the immediate priority for the fund is artificial intelligence and machine learning and process automation.

“With the vastness of data (available) having the ability to work through data in a meaningful way is crucial. It will augment what the investor or PM will be doing. In the next few years, we will be using advanced technology to generate alpha,” he says.

 

The $197 billion Teacher Retirement System of Texas, TRS, has kicked back against its proxy advisor ratcheting up voting powers on companies subject to its benchmark policy climate provisions.

In a recent board meeting, TRS trustees discussed how companies themselves are best positioned to manage their own climate policies and that proxy benchmarks can be too prescriptive. Rather than blindly follow climate voting advice, TRS will introduce a customised benchmark to give the fund the freedom to vote alongside corporate management on climate policy in accordance with the pension fund’s best economic interests.

“Climate action plans are best left to company board and management’s evaluation of the feasibility and financial impact that such programs may have on shareholder value,” said meeting statements.

TRS has used Institutional Shareholder Services (ISS) – one of the two biggest proxy advisors alongside Glass Lewis – to analyse, recommend and vote on thousands of issues from executive pay to diversity at annual meetings on its behalf since 2013 based, in the main, on ISS’s benchmark policy guidelines. Now recent changes to the benchmark that beef up ISS voting policies against directors slow on climate disclosure and emission targets have made TRS wary.

The pension fund is seeking to develop a custom policy to vote on climate proxies in accordance with its own guidelines, philosophy, and best interests. Noting that an increasing number of sophisticated institutional investors are transitioning to a custom policy to implement their own viewpoint and avoid proscriptive guidelines, Ryan Leary, overseeing TRS’s proxy committee, recommended the fund institute a bespoke policy that makes moderations to the benchmark policy climate provisions.

“According to ISS, a majority of clients with TRS’s profile, customise or are in the process of customising, ISS’s voting policies. Clients using the benchmark policy have shown increased interest in customisation recently,” said meeting statements.

The discussion comes against the backdrop of vocal campaign groups arguing that investors have an over-reliance on the recommendations of proxy advisers. On the other side of the fence, climate campaigners are urging investors to do more to influence corporate climate strategy.  The discussion also offered a window into the value TRS places on its proxies. Board members heard about the importance of the fund retaining control of a valuable “trust asset,” and how it must be well-managed to ensure TRS’s best interests around risk and long-term policy.

While agents like ISS have a slate of polices in place, sometimes these policies don’t tally with the best interests of the fund and benchmark recommendations need a tweak. The board heard how voting is a fiduciary duty and discussed the importance of TRS avoiding a herd mentality. In 2021, TRS voted on 64,687 ballot items at 4,716 companies at 6,458 meetings in 68 countries.

New climate additions to ISS’s benchmark policy include voting against directors at companies without appropriate direct emissions reduction targets, and insufficient disclosure based on a framework established by Task Force for Climate Related Financial Disclosures (TCFD).

In a reflection of growing shareholder pressure, in 2021 the number of ‘Say on Climate’ proposals jumped across the globe with ISS voting to ask companies to publish a climate action plan, and to put it to a regular shareholder vote. In other benchmark modifications, ISS has also expanded gender and racial, ethnic targets in US, Canada, Japan, UK & Ireland.

Alongside favouring a customised approach over ISS’s benchmark policy guidelines pertaining to climate, the board also discussed the importance of a bespoke approach to how TRS votes on Special Purpose Acquisition Company (SPAC) mergers to best protect the fund’s economic interests.

Meanwhile pension funds from Texas recently played an important role in Blackrock’s renewed commitment to invest in fossil fuels according to Reuters, a move that goes further to confuse the position of the manager whose chief executive Larry Fink has touted sustainability as a priority in the past.

Lowering exposure to fossil fuel companies was a key tenet in his 2020 letter where he promised to make “sustainability integral to portfolio construction and risk management” and exit investments that present a high sustainability-related risk, such as thermal coal producers. He also said the manager would launch new investment products that screen fossil fuels.

According to Reuters new legislation in Texas requires the state’s comptroller, Glenn Hegar, to draw up a list of financial companies that boycott fossil fuels. Those firms could then be barred from state pension funds like the Teacher Retirement System of Texas, which has about $2.5 billion with Blackrock.

Last month Blackrock executives wrote to officials in Texas confirming they would continue to invest in and support fossil fuel companies, including Texas fossil fuel companies, and as a large and long-term investor in fossil fuel companies it wanted  to see those companies succeed and prosper.

Railpen, guardian and administrator of the United Kingdom’s £35 billion ($47 billion) Railways Pension Scheme is well known for its belief in the cost and control benefits of inhouse management visible in its large in-house fund management and fiduciary team. Rather than outsourcing stewardship, the investor has also built up an internal engagement team to better align stewardship with its ESG objectives, particularly its ambitious net zero targets.

“We don’t outsource our stewardship activities,” says Michael Marshall, head of sustainable ownership at Railpen. “We are rolling up our sleeves and doing this work ourselves.”

Railpen’s net zero strategy has targets along the way to 2050 set at 2025 (25-30 per cent fewer emissions in the portfolio) and 2030 (50 per cent fewer). With 47 companies making up around 70 per cent of financed emissions, the pressure is on to ensure these companies make most progress on limiting their emissions for Railpen to meet its targets.

“If we outsource engagement to a provider, there is no guarantee that they will target engagement on our largest and most long-term holdings, nor on the themes that we are prioritising,” explains Marshall. “By engaging ourselves we can be much more focused on what adds the most value to how we manage our clients’ money.”

It’s a level of control that is particularly important when it comes to timing engagement and knowing when to escalate it, he adds.

“If we externalised this aspect of strategy, we couldn’t be certain the services rendered would escalate company engagements on a time horizon that aligns with the milestones in our net zero plan.”

stewardship Strategy

Railpen structures engagement both from a bottom up and a top down perspective. In terms of bottom up, the investor seeks to engage all companies in its internal actively managed equity portfolios which is about 80 holdings across three portfolios. This runs alongside a top-down approach via a thematic overlay in recognition that even active investors with a strong record of stock picking are still exposed to systemic risk.

The four themes (the climate transition, the worth of the workforce; responsible technology and sustainable financial markets) captured in the overlay reveal another cohort of companies that can expect Marshall and his team of seven to knock on the door.

“On climate we engage with around 47 companies as part of our net zero plan. These companies contribute 70 per cent of our financed emissions. We also have an exclusions process structured around governance and corporate conduct that runs screens across the whole portfolio, shortlisting around 20 companies for focussed engagement and perhaps, ultimately, exclusion of those companies.”

limitations of Passive

Railpen holds very little passive equity exposure, however it does have some externally managed index allocations with LGIM which also manages stewardship and engagement on the investor’s behalf.

Moreover, Marshall notes that stock allocations in the actively managed portfolio are often repeated in the passive allocation, meaning that in some cases Railpen is already engaging with the company. Large passive houses like Vanguard, BlackRock and LGIM frequently pop up as significant shareholders for many companies and are increasingly influential.

“When it comes to winning votes, companies really want to keep them on side,” he says.

Still, he notes the inherent limitations of the ubiquitous ‘Dear CEO’ letter penned by stewardship teams to thousands of companies in a passive portfolio.

lEven the largest stewardship teams at index investors cannot meet every portfolio company, and the larger the stewardship team grows, the greater the risk of undermining the low-cost benefits of passive investment.

“Passive is a buy and hold strategy: companies know you are unlikely to divest in your mainstream index-tracking portfolios.”

the importance of Relationships

Marshall highlights the long-term nature of Railpen’s bottom-up engagement process. Many holdings in the fundamental allocation date from the beginning of the portfolio seven years ago, resulting in a longstanding stewardship conversations based on trust.

“If a concern surfaces, we would be unlikely to immediately write to the chair. Instead, we might raise our concern in our next company call and then escalate from there if the issue is not getting the attention required, but we are not starting an engagement process from scratch in terms of building the relationship.”

This contrasts with the higher turnover of the quantitatively managed equity strategies, run inhouse by Railpen, where allocations to value, momentum and quality stocks might not come with a long-term relationship.

“Establishing durable relationships of mutual trust with companies takes time if you’re going to do it well” says Marshall. “For our quantitatively run strategies we employ a thematic overlay, focussing on enduring themes rather than idiosyncratic issues at particular companies.”

Within themes companies are prioritised based on size, materiality, equity ownership, and likelihood of achieving change.

Railpen is a member of multiple collaborative initiatives designed to increase investor pressure like the United Kingdom’s Investor Forum. Railpen also uses third party suppliers to advise on proxy voting which talk to companies through the course of the year, advising them how the investor might vote.

“Our success often depends where companies are based. We have good purchase in Europe and UK, but it’s more difficult in emerging markets,” he says.

Alongside climate, Marshall’s team also engage on One Share One Vote. He argues that dual class share structures, which give company founders or the family more votes per share, may suit young, entrepreneurial companies that have just listed. But as a company matures and broadens its shareholder base, it is important investors can hold it to account.

“When investors only have one tenth of the voting power compared to the founder, it’s more challenging for investors to exercise stewardship obligations in the way policy makers want. This isn’t a niche issue as huge companies including Meta and Alphabet have a dual class share structures so many investors will have exposure to this issue.”

 

 

 

 

It is not war between Russia and Ukraine that investors should be concerned about, according to Professor Stephen Kotkin, but the destabilising effects of Russia’s actions that could impact globalisation and harm the west.

“The big geopolitical risk is not the war but that Ukraine gets broken up,” Kotkin, the John P Birkelund Professor in History and International Affairs at Princeton University, told Top1000funds.com in an interview. “A lot of what Russia could do could be very destabilising for investors. Investors should be in favour of cutting a deal.”

Kotkin who is a Russia expert and was shortlisted for the Pulitzer Prize for his book Stalin: Paradoxes of Power, said investors should not looking at the tension itself but what could be done by either side, in particular Russia breaking up Ukraine.

“Things like making their cities unliveable and poisoning the air and rivers, using cyber war to shut down the utilities and repercussions beyond Ukraine because everything is interconnected,” he said. “99% of the world’s communication goes through under sea cables. They are mapped and Russia knows where they are, they could cut them. Globalisation is worth a lot more to the west than it is to the Russians.”

Kotkin said this tension will not stop and Russia can come back again and again.

“I’ve been on record for seven years saying we should cut a deal with Russia over Crimea. It’s the big bargaining chip the western side has for a larger settlement to protect Ukraine but give Russia a stake in the deal.”

Kotkin, who among other things is the co-director of the program in history and the practice of diplomacy at Princeton and a senior fellow at the Hoover Institution at Stanford University, believes it is not in Putin’s interest to go to war.

“There is no support in Russia for a prolonged military war in Ukraine,” he said. “There are all sorts of reasons why Putin is in a bit of a bind here. He could undermine himself by going to war. This is a situation where we need to find a way out, not just for the west and Ukraine but for Russia as well.”

He also believes that President Biden also in a bit of a bind because many of the measures the US is threatening, like economic sanctions, against Russia could boomerang against the west.

“The pressure can be as long as Putin wants it to be. And if he withdraws temporarily he can ramp up again. On the sanctions being threated I don’t think it makes sense for Europeans to go without heat and shut their industry down by cutting off gas. It doesn’t make sense for Russia to be excluded from the SWIFT banking system. The international financial system is worth a lot more to the west than it is to Russia.”

He said one option with regards to the economic sanctions, which was effective during the cold war, could be technology transfer limits.

Generally he believes the west is in a better position now.

“Investors can only hope the Biden administration does up its game, that NATO and the EU stay united, that there is an off ramp and more importantly there is pathway to negotiation for a better settlement where Russia has a stake and Ukraine is protected at the same time.”

In the interview Kotkin also discusses the tension between Taiwan and China and reminded investors that the big problems are always perverse and unintended consequences.

In presenting to the board for the first time this year CalSTRS’ long-time chief investment officer Chris Ailman borrowed an image used by Goldman Sachs in its economic outlook for 2022 of an icebreaker smashing through icebergs.

“Images of icebergs are just the best example of the forecast and the outlook for the year. It’s pretty frightening, there are submerged problems everywhere,” Ailman said in an interview with Top1000funds.com citing the Ukraine and Russia, climate change, supply chain shocks and the ongoing uncertainty of the virus as issues causing concern.

“For at least the last two years we have had central banks pushing us but now we don’t. When we look back at the history of US markets usually after two years of double-digit returns the third year is up but in single digits. But none of that research reflects living through a pandemic. I don’t know we can use the past as a guide given the strange uncertainties of the future.”

With this cautious outlook Ailman is expecting lower returns than the fund has experienced recently. Mind you, it’s 2021 return was a record where it outperformed its benchmark in every asset class to deliver 27.2 per cent for the year against a return assumption of 7 per cent. Standout performers were the large allocation to global equities and the outperformance of the private equity portfolio which returned 51.9 per cent.

“The last two years have shown us the unknowns: two years sitting in our own rooms working in isolation,” he says. “And now with interest rates where they are we expect it to be a tough return year.”

In response CalSTRS is adding to the defensive allocations in its portfolio and concentrating on diversification.

“With rates so low but likely to go higher fixed income may have a negative return for the year. It’s going to be tough to make returns,” he says. “We are finally at the market weight in private equity and had a great return last financial year. But I doubt that can keep up. We are adding to the diversifying and defensive areas, not a tonne to fixed income but other things we think will diversify.”

But when probed about where he is looking to allocate his cautious perspective prevails again.

Ailman thinks the fund is at the limit of what it can do with commodities and is looking at different inflation-hedging investments; he thinks real estate is priced to perfection and the fund is underweight because of a lack of things to buy; he is concerned about private debt because of the flow of money; and while he is watching agriculture and timber he won’t buy “at these prices”.

Emerging markets, he says, have been cheap for two and a half years and are still cheap, but investors are now afraid to allocate.

Overall from a historical price perspective he says most asset classes look like they are priced near perfection, supporting the strategy to focus on diversification.

“We have been a little bullish due to the Fed and that worked well in the past two years. But right now it is hard to have conviction,” he says. “I’m always worried in my spider senses and now I’m super worried about all the things that could happen.”

2022: A focus on net zero

After many years leading the ESG charge in the US among large asset owners, last year the CalSTRS’ board finally made a formal commitment to net zero by 2050 with the caveat it would take a year to figure out the plan to get there.

“If you use Google maps you can pipe in a destination but it has to know the starting point for their to be a path,” Ailman says.

The fund is due to come out with a measurement report in May this year which will map public markets. Ailman says the fund is also working with the real estate and private equity industry on how to measure carbon intensity, noting that many in private markets use estimates.

The fund will also invest in opportunities and look at the portfolio from a risk standpoint with regards to net zero, Ailman says.

“We will make strides this year. We are starting to talk to the board about the path to take, there are multiple routes,” he says.

But Ailman takes a slightly different approach to his view of net zero looking to a closer alignment of Wall Street and the High Street as an indicator.

“I could make my portfolio net zero but if we are not living our lives closer to net zero – like driving electric cars – then as investors we are making a big bet on the future. The world should get there, but the pace of governments is so slow. A good chunk has to come from the companies changing their behaviour,” he says, citing the need for companies like GM to stick to their carbon neutral plan.

His prediction is that from the year 2025 there will be a huge corporate governance push on companies especially if global governments haven’t put demands on consumers.

As part of this focus on net zero a special team within investmenst has been set up to do research – Ailman himself is tasked with doing research on hydrogen.

He says the team will focus on two main areas: climate solutions and net zero and engagement with dirty industry.

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.

Scale trends

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.

Value added

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.”

Public markets

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.