Large superanuation funds are increasingly insourcing investment management opportunities, and many of these funds now feature on many advisers’ approved product lists. FASEA places the onus firmly on advisers to recommend investment products in good faith and with competence, which makes the insourcing investment management trend a highly relevant consideration.
Many large industry funds are moving from a model whereby assets under management are outsourced to external managers toward a model where investment management expertise resides inhouse and assets are managed by staff members of the super fund.
This trend has emerged over the last decade and isn’t limited to Australia; the Ontario Teachers Plan in Canada, for example, 80 per cent of its AUD$250 billion in assets are managed in-house. In Australia the degree of insourcing varies by fund and asset class but hybrid models typically exist, as they do at CBUS (37 per cent internal) and Australian Super (44 per cent internal).
Assessing risks and benefits
Let’s look at some of the pros and cons of insourcing investment management and where the complexity creeps in. The benefits include increased control of the total portfolio and expected lower overall fees to members. Some factors to be aware of are the investment performance of the internal team, the investment talent attracted and retained within the fund, how a team is managed and the transfer of risk that occurs with internalising investment management.
In-house investment management provides considerably more control, as the fund is better able to respond quickly to market movements at a total portfolio level and integrate environmental, social, and governance considerations at every point in its investment process. Further, large funds looking to place money with external managers can face capacity issues – the external manager won’t manage the required amount for the super fund due to the business risk of a single large client or the potential alpha diminution from managing too much.
Finally, owning scarce assets (think Sydney or Heathrow airports) directly also can be very attractive for these long-term asset owners. It often supports a much longer- term ownership horizon than if the super fund invests through an external investment manager who is managing a fund with a 10-year (or less) time horizon and needs to buy and sell the asset within that time frame.
Scaling up fees and costs
Lower fees have been high on the agenda for Australian investors for years and insourcing investment management can generate fee savings for investors. AustralianSuper estimates that its internalisation programme now saves members around $200 million annually.
The fee savings are generated through two main mechanisms. The first is a result of substituting the payment of asset-based fees to external managers for largely fixed salaries to internal staff. Let’s take a relatively extreme example: If a large fund has an equities allocation of $50 billion and it pays, on average, five basis points per annum to an external manager, it is paying away $25 million per annum in investment fees. The other option could be to pay 50 people an annual salary of $250,000 each and reap some cost savings.
The magic is when additional scale is introduced and the $50 billion of equities grows to $100 billion. It is unlikely that a significant increase in staff numbers is required to manage these additional assets, and unless the five basis points of external investment management fees tiers down to 0 basis points, there are significant fee savings potentially available.
The other part of the equation is performance fees. Many private equity, infrastructure, property, and alternatives investment managers command lucrative performance fees for performance in excess of a benchmark. While in-house investment personnel may earn performance-linked incentive payments, they are often much lower in absolute terms and linked to the overall fund performance.
Fee saving and poor performance
While the fee savings available from in-house investment management appear dazzling at first blush, it’s worth considering how quickly these fee savings could be eroded by poor performance. Investment management is a tough game and, unless roughly equivalent levels of competence can be achieved, the potential loss from lower investment returns can quickly swamp any fee savings.
This is a key reason why many funds are selective about the asset classes they insource – they want to internalise strategies where equivalent levels of competence with external managers can be achieved, and that is not necessarily achievable in every asset class.
People and governance
People are a vital pillar to any successful investment management business and are a key ingredient to funds achieving equivalent levels of competence with external managers.
A deep dive into the people in the investment management team, the super fund’s culture, and its remuneration practices is necessary to determine whether the fund has a fighting chance to deliver equivalent returns to an external manager and whether the right investment people are likely to be retained within the fund.
Funds know that retention will be a key challenge – the lure of higher salaries and equity participation at external management firms is real.
The importance of good governance when insourcing investment management should not be underestimated. Internal investment teams need clear objectives, and performance should be measured periodically by both the trustees of the fund and independent assurance reviews. It’s difficult to evaluate investment decision-making over the short term, and it may take years to properly assess whether the internal team is delivering on its objectives.
Finally, insourcing investment management is a transfer of risk; besides the risks outlined above, investment-process-related and operational risks should not be underestimated. The integration of internal and external management into a coherent investment process should be scrutinised carefully; the supporting infrastructure required to adequately manage money is expensive to set up and can be costly for investors if not done well. External managers have often spent years refining their trading, compliance, technology, and back-office support systems.
Internal teams need the same infrastructure, and trustees need to carefully oversee this part of the equation. After all, the contractual protections that come from external management no longer exist, and losses resulting from a large trading error will now be compensated by the fund’s own insurances or its reserves.
There’s a lot to like about insourcing, but it is not for every fund and investors should be aware of what can go wrong. For advisers to recommend one of these investment products in good faith and with competence means understanding the inherent complexity inside these behemoths. These funds are anything but light touch from a due-diligence perspective.
*Annika Bradley is the director of research ratings at Morningstar Asia-Pacific
An interesting analysis. It is interesting that the lower costs of in-sourcing does not appear to have been reflected in lower ICR for the major super funds I follow. Either ICR is not being recorded accurately or the ‘savings’ are being expended elsewhere.