US Pension Funds searching for higher returns in Alternatives

US Pension Funds searching for higher returns in alternatives:  A high risk, low reward strategy?

“We can’t put it (funds) in Treasury notes and bonds; that’s just not making any money,”…This comment by a Pension Fund Manager justifies the flight by some of the US pension funds in to HFs asset class in last three to four years. 

According to a recent market survey, Investment in hedge funds (total hedge funds and hedge funds-of-funds) among the 200 largest U.S. retirement funds jumped to 20.3% to $134.7 billion.

One point of view is that this ‘flight to alternatives’ (higher allocation to HFs, PEs, Alternatives) was more of a knee-jerk reaction to the credit crisis of 2008 and the consequent financial market collapse.  To understand the real picture you have to stack up the returns from Hedge Funds as an asset class among other asset classes over a longer period –at least 10 years.

Our analysis shows that Hedge Funds as an asset class outperformed S&P 500 only in two out of the last ten years and if you compare the performance with  Non-US equities (HFs being a riskier asset class), it outperformed Non-US equities in only three of the last ten years.  Refer to comparative asset class analysis below.


US Pension funds are adopting aggressive investment strategies by higher allocation to Hedge Funds.   This trend is driven by a desire to generate higher returns (given the funding gaps).  The decision is also fueled by the fact that currently investments in HF’s form a small component of aggregate asset allocation (it currently stands at around 2.5% of total allocation).  If you compare this with some of the top Canadian pension funds the comparable percentage is about 3.5 % of total asset allocation.

However, these funds need to be cautious given that the high cost incurred in investing in HF’s is not necessarily backed by higher returns. In 2012, the HF industry generated returns of around 8.5%, which is way below S&P 500 returns of around 13.4%.  And finally, the expectation of high returns from Hedge Funds comes at a significantly higher cost.  Typical, external Manager fees for Hedge Funds asset class is approx. 5 times compared to domestic equity assets and around 8 – 10 times compared to various sub segments of fixed income asset classes.

It is clear that betting on riskier funds does not necessarily yields higher returns.

‘In-sourcing’ of Asset Management. Are Institutional Investors ready – Part 3

Factors that Institutional Investors need to consider for in-sourcing of asset management

My previous post covered some key factors that Institutional Investors must consider in their decision to commence or increase ‘In-sourcing of the Asset Management’ function (internal management of financial assets) – (

Recap from last post and Key Statistics – Cost vs. Returns

Before I take a deeper look at the subject, it is important to clarify that any ‘in-sourcing’ decision should not be based solely on the cheapest available alternative with respect to management fees.  Many studies have shown that internal asset management typically has significantly lower costs than external management; – in certain cases the savings are as high as 80% – 90%.  Additionally, institutional investors also gain from enhanced governance.   Managing funds internally with complete control and no conflicting interests typically means higher returns than the average returns provided by multitude of external asset managers.

Learning from some of the most successful pension funds, having largely internally managed assets, I observed that they exceed the average peer fund performance significantly.  To take an example of a Canadian pension fund (having approximately $115 bn AuM) – fund’s 2011 total return of 9.8% exceeded the composite benchmark return by 1.4 percentage points (historically this fund has exceeded the peer performance in all of last ten years) and that’s an excess return of approximate $1.4 billion above the benchmark for one year.  This excess return, in part, can be attributed to what I call a ‘governance synergy’ – excess returns from improved governance and control.  This synergy creation is based on the premise that the entire investment governance machinery works in line with the established investment policies / goals and right enablers of governance are in place.  A study by Ambachtsheer et al. (2007) also established that the impact of good governance can be as high as 1.0% to 3.0% of additional returns per annum.  You can do the math – typically it would mean at least $1 billion for a mid size US pension fund.

Spend on the internal Investment Management organization

A number of US pension funds we have studied have an annual payout of less than $4 million for the investment staff (of approximately 20 – 30 members) that oversees a big pension fund portfolio.  Clearly this is a fraction of an annual wage bill of a professionally managed asset management firm of equal size – undeniably, a key road block.  It is ironical that many pension funds would pay out a few hundred million dollars in fees to numerous fund managers for an ‘average’ or ‘below market’ returns.  Clearly there is an enormous incentive to be captured and retained for those who truly deserve it – the ultimate beneficiaries.

That said there is no ‘magic pill’ to implement such a critical decision.

In-sourcing decision requires overcoming enormous challenges and reforms, most important one being – getting the stakeholders to agree….

When we talk to a number US pension funds, some of the most frequently quoted challenges in implementation of in-sourcing strategy include (not an exhaustive list):

►   State laws and Board structure

►   Governance frameworks and legislative hurdles

►   Inability to attract ‘best-in-class’ talent

►   Compensation plan for investment staff

►   Inadequate investment support infrastructure, trading relationships

►   Inadequate legislative authority for governance budget

►   Lack of investment culture and organizational maturity to manage market risks, etc.

Every institutional investor has different investment objectives, management structure, investment and risk management capabilities, governance processes, and available infrastructure.  Thus, a comprehensive capabilities assessment is imperative before taking this decision.

However, driving the larger strategic change in the mindset of all stakeholders (Trustee Boards, Comptroller, Investment Boards or Councils, Senior Executive Members, etc) towards internal asset management is the most critical decision in the process and the most painstaking one given the politicized investment process, inertia, fear of unknown and conflicting interests of members of the entire governance machinery.

Once that is done, administrative reforms are imperative to tackle the multitude of challenges such that the overall implementation becomes easier and successful e.g. how do you overcome the long procurement process to hire a new fund manager or a best-in-class technology or research vendor or even to get new investment positions approved for building the investment organization.


But, there is good news…

Speaking purely from the ‘ability to execute’ the in-sourcing strategy, I believe, it is a much easier decision today when compared to ten years ago when I was facing a decision to in-source.  At that time the ecosystem was not fully matured, the talent supply and demand equation was skewed, and the vendor support landscape was evolving.  Significant investment and management bandwidth was required to build full scale middle office / back office and risk management infrastructure.  Most importantly, investment talent was a priced possession and pension funds could not compete with the Wall Street salaries (this still holds true).  Today, all of these factors have evolved for investors’ benefit and the ecosystem is much more investor-centric for Institutional Investors who are considering in-sourcing.

I must mention here that there is some great progress being made by some visionary State Treasurers.  We have been hearing from some of the state pension funds that have had full support from the Board trustees, unions and other stakeholders to bring the assets in-house as there are vested interests to keep the costs low such that the impact on benefits is not significant.  At the end of the day it is a trade-off.

I believe funds do not need to replicate an extensive Fund Management organization structure in their organization.  These funds can not only follow the best practices from other successful pension funds like some of the Canadian funds that have large part of their funds managed in-house, but also evolve those best practices into ‘Next Practices’ by leveraging ‘Capability Sourcing’ strategies as I describe below.

Evolving the ‘Best Practices’ in to ‘Next Practices’

One challenge that we keep hearing from pension fund clients is how to attract the best-in-class talent away from private sector managers into public sector pension funds.  One ‘next practice’ I see evolving is the emergence of a new model that learns the best practices from Asset Management industry and the larger Banking industry.  I call this as ‘Capability Sourcing’ strategy i.e. an operational strategy to create or leverage best-in-class capabilities for key functions and processes in the value chain to ensure profitable growth and sustainable competitive advantage. 

Financial services industry was an early adopter of global capability sourcing model.  Many US Banks started to expand their processing centers in the US in early 80s and outside of US in mid 90s.  Most of these Banks had created mid to large scale centers or made majority investment in companies that leveraged global geographies for processing of middle and back office functions by late 90s.  Almost all of the top 10 Investment Banks and Global Banks had commenced some form of global sourcing by early 2000.  Today, the global outsourcing by banking and financial services industry is approximately $80 billion.  Learning from the industry’s best practices and evolving that model to create profitable growth and sustainable competitive advantage, following are key ingredients of this ‘Next Practice’:

  1. Hire the Best minds in Fund Management for core investment leadership
  2. Create a clear mission and vision statement.  Articulate the fund’s investment philosophy and strategy in the light of the long term mission and taking in to account organization’s capabilities and the resources
  3. Set up operations away from Wall Street (there are many successful examples of Asset Management firms in Canada and US)
  4. Create a strong culture of governance, systems and controls.  Invest early in creating unbending governance policies and key leadership to increase the agility and responsiveness to brutal nature financial markets
  5. Source large part of investment research and portfolio monitoring capabilities from credible providers (refer below for number of Investment Banks and Asset Management firms leveraging this model)
  6. Leverage low cost domestic regions (even countries for sourcing capabilities) for middle office and back office functions to keep lower Total Cost of Ownership (TCO)
  7. Source the enabling infrastructure from credible partners around fund accounting, trade processing, portfolio attributions, reference data management, enterprise data management, and middle / back office functions.
  8. Build trading relationships
  9. Invest in risk management and technology enablers
  10. Create a robust operational risk management culture with clear metrics and operational risk management processes and governance – measuring all possible risks and creating measures of controls are critical to success.
  11. Leverage cloud capabilities for IT infrastructure management and IT services

Key statistics of Financial Services firms that leverage this ‘Capability Sourcing’:

  1. Traditional Asset Management Firms – 2 out of every 3 top 30 firms already leverage this model
  2. Alternative Asset Management Firms – 68% of the top 50 firms
  3. Insurance companies – 45% of the top 50 firms
  4. Global Investment Banks – 17 of the top 20 Global Investment Banks
  5. Many Sovereign Funds and family offices

The support ecosystem to the Investment Management industry and has evolved enormously in the past fifteen years.  As a key player in the ‘Business Capability Sourcing’ services industry, Sutherland provides investment research to more than 40 global Investment Management firms and over 200 large Corporates.

Email me at for more information on operationalizing the capability sourcing model.  Sutherland has long standing experience in creating operational strategies to leverage best-in-class capabilities for more than 25 years with more than 50 of the Fortune 500 companies.

In my next post, I will talk about which asset classes are optimal for in-house asset management and the state of in-sourcing.

In-sourcing of Asset Management. Are Institutional Investors ready – Part 2

Factors that the Institutional Investors need to take in to account for the decision to in-source


In my last post, I discussed how in-sourcing of Asset Management is a growing trend amongst Institutional investors and why it is important for Asset Managers.

In this post I will discuss factors that Institutional investors need to consider in making this strategic decision – In-sourcing of Asset Management.  I also want to underscore that these ongoing industry trends can have an impact on the overall global financial markets as well – viz. broadening of certain asset classes like passive asset management, increasing specialization by asset managers and thus impacting market efficiency and liquidity in certain asset classes, etc.

Before we get to the factors, recall that one of the fall outs of the Credit Crisis was the erosion of investor’s confidence in the professional Asset Management function.  I covered that in my post on ‘Key Challenges and Structural Shifts facing the Asset Management Industry’ (
Consequently, institutional investors were forced to go back to the drawing board and reassess the true benefits derived from professional Asset Management with respect to returns, risk management practices, governance, diversification in asset classes, exposure to alternatives, and access to best in class investment practices in research and portfolio management.  The result: institutional investors have started to change the way they do business, and, more importantly, some leading US public pension funds have been leading the way in this new trend.

The following are some of the key factors that need to be considered to In-source the Asset Management function:

  • Asset Classes: The most important factor for your decision will be the Asset Liability needs and your current investments in public markets (fixed income and equities) vs. private markets (private equity, alternatives, and real estate).  That said, I reckon that the most important discussion point about these asset classes is not public or private markets but about liquidity, transparency (availability of benchmark indices) and apparent efficiency in these markets.  I will cover more about this important consideration in my next post with examples on US domestic equities vs. international equities, fixed income, real estate, and other assets.
  • Expectation of Returns: Institutional investors are sophisticated and have a very clear understanding of the difference in “Fee Savings” (internal vs. external cost of producing risk-adjusted return).  What about the returns or expectation of returns from the internal investment management team?  To answer that, Institutional investors must know that the process for producing risk-adjusted returns is universal and, among other factors, the core factor is the reliance on the right Asset Managers (and investment teams) from the same available talent pool.  Hence, theoretically the returns should be similar.  Needless to say there would be individual asset managers who would perform better than others because of the interplay of other factors in the process at various points in time.  Also, it is imperative to have appropriate infrastructure and cultural alignment to produce these returns, such as the team’s empowerment levels, access to market information, risk management & governance, investment compliance and controls, technology access, and other factors).  Refer to the details below on ‘Suitable Infrastructure’ for other factors important in producing the risk-adjusted return.
  • Attracting the RIGHT and BEST in class talent: Any decision on In-sourcing/incremental In-sourcing would mean hiring the right kind of talent to manage the In-sourced assets e.g. Chief Investment Officer (CIO), Directors of Research, Research staff, Portfolio Managers or Fund Managers, and Investment Officers, etc. Though this may seem like a daunting task, this is not as uphill as it may seem.  Furthermore there are a number of alternatives available today to outsource a large part of the research operation, especially the low and middle management, to a professional research firm that has interests more closely aligned with the institutional investors. I will cover the best practices and next practices in outsourcing Investment Research and Portfolio Analytics in my next post.
  • Fee Structure: A 2011 Sutherland Research study on costs associated in managing Assets internally vs. professional asset management showed that about 20 of the world’s largest institutional investors spent a weighted average of 55 basis points on external management as compared to weighted average of only 10 basis points on internal investment management.  The difference in basis points was somewhat higher for the next 30 Institutional investors.  It is clear that institutional investors are critically evaluating the pros and cons of professional asset management.  Institutional investors considering on embarking in this route must assess their asset-liability objectives, current investment portfolios, and fee payments, and gather intelligence on their peer-set before making the decision.
  • Governance Structure of Public funds: Some large institutional investors have a well-defined governance structure and any decision on in-sourcing requires approvals from key stakeholders. E.g. in the case of a Public Pension fund, the Board of Trustees must approve the fund’s governance structure. Hence, a buy-in from the Board of trustees is critical for any change in strategy pertaining to In-sourcing/incremental In-sourcing.  How do you go about convincing your Board of Trustees?  Historically, a fund would shell out about $1.5 – $2.5 mm and hire a consulting firm to advise on a strategic decision such as In-sourcing. However, today some of the smartest institutional investors have taken an alternative route by allocating an internal champion or sponsor who runs formal processes (RFIs / RFPs) with well known providers of front end, middle office and back-end processes, and saves a substantial amount in consulting fees.
  • Suitable Infrastructure: Institutional investors must create the appropriate infrastructure and culture to produce risk-adjusted returns.  Today, investors can access the services of the right partners in supporting this strategic task.  Today, an entire eco system exists to assist in this process, where institutional investors can use investment research and management services from firms such as Sutherland Global Services (  Sutherland works with more than sixty financial institutions, including 8 of the world’s top 10, to enhance the investment management process. Among many systems and processes, investors need to leverage or put in place the following infrastructure or processes to replicate the best practices of any large asset manager:


    • Investment Process – Creation of a robust Investment process – a multidisciplinary process driven by fundamental research with an emphasis on the firm’s investment philosophy and asset liability objectives.
    • Market information: Reliable sources of dynamic market information pertaining to pricing, capturing both liquid and not so liquid instruments across the globe
    • Risk Management tools: A robust risk management system needs to be in place which captures detailed portfolio information/analytics.
    • Compliance monitoring: The Investment Management function brings with it a whole host of compliance requirements. Hence, it is of utmost importance to have in place a system which takes care of the regulatory, taxation and internal investment policy compliance requirements
    • Trading Relationships and Settlement of transactions: In-sourcing will result in forging direct relationships with brokers (which was otherwise taken care of by external managers). A good network of large and regional brokers is needed to be able to get the best trades.  Similarly, the settlement of transactions means forging relationships with parties (custodian banks) providing settlement & reporting of transactions and the safe-keeping of assets
    • Reference Data Management: Managing the entire spectrum of a transaction would mean challenges pertaining to Reference data Management and suitable tie-ups with external players are needed.
    • Fund Accounting:  In-sourcing would result in the direct management of relationships with Fund Administrators.

The above challenges pertaining to the middle office and back office can be addressed through forging right partnerships with credible vendors and by leveraging global shared service business models. Watch out for one of our future posts on “How to leverage the recent developments in global shared services models (not only for middle office / back office but for Investment Research, Investment decision support and monitoring) to succeed in your In-sourcing strategy.”

In-sourcing of Asset Management. Are Institutional Investors ready – Part 1

Last week, I spoke about the structural shifts happening in the Asset Management industry.  This week I will focus on one of themost recent and prominent trends –‘In-sourcing of Assets Under Management’.

Well, one of the key questions occupying the minds of Financial Institutions (Pension Funds, Insurance Companies, or Central Banks, Endowments, etc.) today is which form of Asset Management is optimal for the beneficiaries (be it Institutional investors or trusts or plan beneficiaries, etc.) – Professional Asset Management or in-house Asset Management by the Institutions themselves or a combination thereof.

For those who believe in numbers – a recent survey by Sutherland Global Services of 40 Institutional Investors -Insurance companies, corporate defined benefit  plan sponsors, as well as endowments and foundations showed that only 21% of the firms that have external asset managers were satisfied with the asset manager’s investment performance.  

Another research study by Sutherland conducted between June and Sept 2012 showed that of the top pension funds in Australia, UK, US, and Canada approximately 21 of them brought back more than $65Bn AuM in-house in last twelve months.   


Some of the large Institutional Investors taking the plunge to in-source the Asset Management (partly or fully) in last six months included:

►   CalPERS – approx. $1bn

►   AMP, Australia’s largest retail and corporate superannuation provider, brought back ~$6bn management of the fixed-income assets in-house to ‘AMP Capital’

►   AustralianSuper brought close to $3bn of equity investments in-house

►   State of Wisconsin Investment Board is moving $3.9bn of externally managed international equity assets in-house

Why is this trend critical?  ‘In-sourcing’ of Asset Management is not new but the rate at which it is increasing has never been higher and the value of Asset brought in-house never been so massive.  Institutional Investors’ realization of ‘cost adjusted returns’ heightened when they saw their portfolios dwindle in the wake of financial markets collapse in 2008. Also, Institutional Investors today know that funds management is largely a fixed-cost business while their current fees to the external Asset Managers are not.

Case in point – The Teachers Retirement System (TRS) of Illinois – paid more than $1.3 billion for money managers and brokerage firms to handle its $30 billion-plus in financial assets during a 10-year period ending in fiscal 2010. Despite this high fee – TRS’ 10-year average rate of return during this span was ~ 3.7 percent excluding the cost of fees, far below its 8.5 percent annual target return (Source:  Well part of this dismal performance is attributed to market crash of 2008 and the portfolio recovered in 2010 and 2011.

Another example – Australian superannuation fund, AustralianSuper’s brought $3 Bn in-house (  Its head of investment operations stated in September 2012 that the fund spent about $200 million a year in external investment-management costs and predicts that if this was to continue they will end up paying about $500 million a year in a few years.  AustralianSuper plans to cut costs by about two-thirds by moving it internal.

Bottom-line – ‘Economics is in force’.  Differential between the cost of external asset management fee vs. the cost of managing it in-house is driving the latest structural shift.  Control over the investments as well as governance around the investment management process are also some of the other key factors.

In part – II and III of the series I will cover topics on ‘New Normal’ for the Asset Management industry including:

►   Factors that the Institutional Investors need to take in to account for the decision to in-source.

►   Which asset classes are most optimal for in-house Asset Management?

►   How to leverage the recent developments in global shared services models (not only for middle office / back office but for Investment Research, Investment decision support and monitoring) to succeed in your in-sourcing strategy.

Structural Shifts in the Asset Management Industry

There were many fall outs of the unprecedented US housing market collapse and Credit Crisis of 2008 – liquidity crunch, economic recession, closure of century old financial institutions, job losses of 8.8 million between 2007 to 2009 (source Bureau of Labor Statistics.  Job losses in 2008 of 2.6 million or the highest level in more than six decades (source::CNN Money, rapid erosion of investor’s wealth.   One of the biggest fall outs of the Credit Crisis was erosion of investor’s confidence on professional Asset Management function.  The lingering effects of that can be witnessed in the key drivers of the Asset Management business – Net Flows; Active Assets Under Management (AuM); Fee Rate; and Growth rates of Active vs. Passive Products.

The Global Asset Management industry continues to witness mounting headwinds. Yes, the post crisis rebound of late 2009 and early 2010 gave the required boost to the operating margins.  However, three out of every four of Global Asset Managers agree that the industry is undergoing fundamental structural changes.

Key Challenges and Structural Shifts facing the Asset Management Industry

  • Flat AUM - Professionally Managed Assets remain flat at 2007 level ($58 trillion)
  • Declining Net Flows – Net flows averaged at 0.2% p.a. between 2008 and 2011 compared to an average of 4.7% during 2004 to 2007
  • Increasing trend of ‘In-Sourcing’ - An analysis of 50 global institutional investors shows that investors have brought ~$65 billion worth of AuM in-house in last 18 months
  • Rising Regulatory Management Cost – Operating margins will continue erode due to implementation of current and evolving regulatory requirements (Dodd Frank, FATCA, MiFid, etc.)
  • Growing significance of Emerging Markets - Allocation to emerging markets has doubled in the last six years.  Substantial diversity exists in political and business environments in Emerging Markets requiring strong local operational expertise to generate Alpha
  • Shifting investor preferences from ‘Active’ to ‘Passives’ and Alternatives - Actively managed professional assets are declining.  Passive Asset Management products grown five times as fast as ‘Actives’ in the last seven years (2004-2011). Allocation to Alternatives has been steadily growing since 2008.

A number of the above changes are structural and will have long term impact on the operating model of Investment Management firms.  We believe that winners of tomorrow will do a thorough reassessment of business models, customer acquisition and retention practices, operating capabilities and governance frameworks.

In the next post, I will discuss, what are the ‘best practices’ that some of the best in class companies are deploying.  Also, look forward to the future post on what could be the ‘next practices’ for the Asset Management industry – an industry in rapid change and transition.