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’ (http://info.sutherlandglobal.com/blog/fund-manager-minute/bid/160329/Structural-Shifts-in-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 (http://www.sutherlandglobal.com/services_kb_fr.aspx). 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.”