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) – (http://info.sutherlandglobal.com/blog/fund-manager-minute/)
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’:
- Hire the Best minds in Fund Management for core investment leadership
- 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
- Set up operations away from Wall Street (there are many successful examples of Asset Management firms in Canada and US)
- 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
- 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)
- 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)
- 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.
- Build trading relationships
- Invest in risk management and technology enablers
- 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.
- Leverage cloud capabilities for IT infrastructure management and IT services
Key statistics of Financial Services firms that leverage this ‘Capability Sourcing’:
- Traditional Asset Management Firms – 2 out of every 3 top 30 firms already leverage this model
- Alternative Asset Management Firms – 68% of the top 50 firms
- Insurance companies – 45% of the top 50 firms
- Global Investment Banks – 17 of the top 20 Global Investment Banks
- 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 email@example.com 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.