Recently there has been an increasing trend for large asset owners (pension funds, sovereign funds, etc) to insource the investment management functions. Whilst this has obvious cost benefits and can increase the perceived control of the functions there are a number of factors that Boards need to consider.
CalPERS (responsible for the California Public Employees' Retirement Scheme and the largest public pension fund in the US) recently set an external fee reduction target for the financial year, in light of the fact it spent more than $1 billion on external asset management fees in 2009-2010 and only a relatively modest $29.5 million on investment office personnel services including salaries.
About 62 per cent of CalPERS’ assets are managed inhouse, compared to about 33 per cent for its global peers according to a database put together by CEM. External asset management fees at CalPERS accounted for 90 per cent of the $1.2 billion in total investment office costs in 2009-2010. The other costs were personnel (3 per cent), portfolio management tools (2 per cent), consultants (2 per cent), legal and audit fees (1 per cent), appraisal fees (1 per cent), enterprise overhead (1 per cent)
Although the reduction in investment management fees in a laudable goal trustees need to consider the additional costs that will be incurred as a result of support these functions inhouse.
Potential for Underperformance
It would be uneconomical for Trustee to employ a full range of fund managers to cover all asset classes (including research team). Then a decision needs to be made on which sectors will be managed in-house and which will be outsourced.
Employing a team of fund managers also has its pitfalls. Leaving aside the problem of recruiting the managers with the right level of skills and experience, the pension fund is committed to using the skills of those managers it has recruited. Should market conditions dictate a change of strategy, a small investment team may not have the breadth of skills necessary to adapt to the new requirements. The fund then runs the danger of allowing the asset allocation to be dictated by the skill set of the fund managers it has hired.
Operational Costs
Operationally from insourcing, the pension fund becomes legally liable to meet an expanded range of increasingly complex reporting requirements, which adds to the overall management cost burden. The pension schemes that want to take control of the fund management process may also have to take on responsibility for middle and back-office functions.
Previously, these functions would have been managed by the fund manager, who to some degree acted as gatekeeper. In the wake of the financial crisis and the Madoff scandal, pension funds have wanted much closer control of these functions. Valuation, performance data, risk analysis and other services give the trustees a much more detailed picture of the state of their scheme's liabilities, but they come at a price.
Data Requirements
Many of the investment activities in which Pension fund trustee's are involved, such as the implementation of tactical asset allocations or the equitisation of cash balances, require visibility of the entire fund’s assets, often down to a security level. Typically service providers to investment managers have typically delivered portfolio data at an individual portfolio or product level with limited requirement to ‘roll up’ this data into consolidated structures to enable an overall view of portfolio positions. Trustee's insourcing investment management may need to consider the ability of their service providers to provide consolidated data or an investment in a data warehouse that can provide similar capabilities.
Risk reporting
A key incentive for insourcing investment management has been to provide improved risk controls. As part of the review of insourcing an analysis needs to be completed on the existing risk management systems and the reliance that is put on reporting from current investment managers. Risk management systems are typically expensive and complex to implement. Service provider offerings in this space have typically not provided the total fund perspective such as value-at-risk (VAR) and simulation testing.
Front Office Systems and Processes
Most investment managers have existing technology to support investment processes such as portfolio management and dealing. Where pension funds have made the decision to insource investment management they will often not have front office systems in place, and will need to select and implement these platforms. The expertise required to select and implement this system may not reside inhouse and could result in a protracted transition period.
The decision to insouce investment management needs careful consideration including an analysis of the operational and support costs.
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