To do or not to do?

A look at in-sourcing trends in Australia’s big superannuation (ie. pension) funds, by Prof David Gallagher, an ‘accidental academic’ and investment management scholar

Every year, Sanlam Investments’ aims to bring you thought leadership from all corners of the globe, and this year was no exception, leading us ‘Down Under’ to one of Australia’s finest capital market researchers and self-proclaimed ‘accidental academic’, Professor David R Gallagher.

We recently hosted a luncheon engagement with this widely published expert of international standing in investment management and capital markets.  Gallagher shared insights from some of his pioneering research on in-house investment management, proposing a framework for asset owners to make and implement decisions to manage investments in-house. This framework primarily addresses four elements: capabilities, costs, alignment and governance.

Gallagher believes it is important to be able to interrogate certain assumptions that underpin trends in the superannuation pension fund industry, particularly the major trend to ‘in-source’ investment management to pension funds or super funds. Further, he says the, “ Australian context is very similar to that of South Africa (and other developed markets) and we have some rich insights, backed importantly by robust empirical evidence, to share”.

What are the key trends in Australia?

Australia’s big pension fund (i.e. superannuation) industry has a massive $AUD2 trillion dollar (approx. 18 trillion Rand) savings pool  – the fourth largest of any savings pool internationally –  a country with only 24 million people. In-house investment management is a particularly hot topic in the Australian superannuation industry, where an increasing number of funds are becoming large enough to justify bringing some of their investment management capabilities in-house. Given the size of the assets under management, super funds are increasingly looking at how to optimise scale and acquire greater risk return opportunities for their fund members. There is a growing trend for big super funds to complement their external investment function by recruiting their own in-house investment management teams, to trade in markets with their own brokers, carry out their own private equity deals, and to manage some of their aggregate assets in-house.

In the past, this function was largely outsourced exclusively to external managers, who were given a mandate and measured according to that external mandate. As super funds get larger in the future, however, says Gallagher, they will increasingly look to embrace this growing opportunity and, going forward, we can expect to see many more funds adopting similar insourced arrangements in concert with external mandates.

Why would pension funds decide to insource?

The research suggests that there is no exact science to when and why super funds would choose to in-source. However, there is an abundance of anecdotal reasoning supporting a vote in favour of insourcing, including the fact that a number of CIOs were former fund managers and believed their skills as traders could benefit the overall pension fund.

75% of participants indicated the following drivers of their decisions to bring assets in-house:

• Better net returns: many pension funds believe they can they get better returns than external fund managers by saving money on fees and external costs.
• Improved scale: As funds become larger, it is imperative to have a capability that offers scalability in the way they execute their investment arrangements. Certain capacity constraints exist with external active managers.  As you get bigger and you’re an acting player, it can be difficult to beat a benchmark. Ideally, you need scalability and would want to incubate something scalable within.
• Alignment: Insourcing allows pension funds to tailor their portfolios to better align with their investment objectives, giving the benefits of time and flexibility. Determining the rules of engagement and how to structure incentives may be challenging with external fund managers.
• Competitive advantage: managing funds in-house cultivates an attractive amount of in-house skill, knowledge and control over the investment management process. You can incubate a unique team who understands your assets and investments intimately, has a better grasp of the insights, and understand risks and returns in portfolios.
• Governance, control and oversight: Insourcing enables funds to better oversee their governance processes, particularly those functions that carry inherent risk.

Divergent views and lack of consensus

On the other hand, however, in-sourcing also has its challenges and limitations. Will the pension fund have adequate capacity to implement?  Smaller pension funds may not have the appropriate economies of scale, systems or infrastructure in place to optimally manage the end-to-end investment process, and it is broadly acknowledged that this is needed to enable functions such as trading, portfolio and risk management, reporting and compliance.

Will pension funds be optimally equipped to manage the risks associated with compromised governance when independence of the board is not guaranteed?  Human capital is another important consideration, and attracting and retaining staff that are both skilled and culturally aligned with the organisation, is critical. “You get what you pay for”, says Gallagher. As a super fund, can you compete with the higher-paying, bigger asset managers attracting the superior talent? Can you incentivise your staff appropriately based on performance? To attract and retain top talent, you have to be prepared to pay a premium. But what happens with poor performance? You can’t subject them to an asset consultant review and simply terminate an under-performing team, as you would an external fund manager. If you’re running an in-house strategy, you can’t just sack a team.

The culture of the organisation is equally critical. Bringing  in  highly-paid  investment  teams  may be perceived   as  culturally  challenging  to organisations that have traditionally been used to out-sourcing . Culture feeds from the top down and has a major impact on the operational success of fund organisations and the way they are run. The ultimate challenge remains how to create a top-performing, highly aligned team capable of successfully contributing via an in-house strategy.

So, ponders Gallagher, is the decision to in-source about enhancing returns or simply reducing costs? More likely the latter, muses Gallagher, although no pension fund managers would be held to account for saying so specifically. For context, in years gone by it has been difficult for pension funds to apply downward pressure on  fund managers’ fees due to competitive pressures. In around the last ten years, asset sizes have doubled yet fees have not halved. So where are the economies of scale to be shared between external managers and pension funds? Tensions therefore exist with external fund managers and big pension funds, seeking to delineate  an appropriate share of the value versus benefits being derived from the contractual investment arrangement. Insourcing would therefore be a natural way to help tip the balance in applying further downward pressure on external investment management fees charged by the industry.

“I’d say cost and performance are equally important. … Actually the risk-return payoff is probably quite skewed in terms of lower cost and [lower] performance.” Anonymous

“It’s all about performance at the end of the day. After-fee performance. … The best way to get strong after fees/after tax performance is to reduce agency risk, to reduce costs, and to improve decision-making. … If you make better decisions, you make them quickly, you do them without the agency risks, you do them at a flat cost. And then why do you make the decisions better? Well you’ve got more information; you’ve got more understanding.” Anonymous

The ultimate question is: can you beat a fund manager?

If superfunds were to set up their own internal investment management teams, could they outperform a fund manager? Not necessarily, says Gallagher. External fund managers will continue to play an important role, but it’s likely to be a complementary relationship.

While the research supported the trend to in-house management, the conditions must be right and properly implemented, concludes Gallagher. Governance, HR, calibre of your staff and organisational culture all become critical when running investments in-house.  The big challenge is that it all comes down to people. Hiring and retaining consistently top-performance people remains the overriding difficulty.

The superannuation fund industry will increasingly embrace insourcing, particularly as the market size and asset pools get larger, predicts Gallagher. And while the advantages are undeniable, there are challenges too. When you’re running money, you need proper compliance, risk management, systems and processes in place.  You need to incentivise, attract and retain staff. But as the superannuation savings pool grows, insourcing will increasingly be part of the pension fund landscape globally.

What is the role played by external consultants?

External consultants will continue to play a critical role in terms of reviewing external managers, and pension funds will continue to rely heavily on asset consultants. Asset consultants will help review their external managers and can give them independent feedback and investment advice on the investment process that is being adopted by the internal team. It may be ‘early days’ for in-house investment management in terms of the quantum of assets under management, but we believe the trend will continue to grow, implying a greater role for asset consultants in support of this trend.

Certainly, external fund managers will not be replaced, but a certain complementarity and symbiosis will exist between pension fund managers, external fund managers and asset consultants in managing their investments in-house, says Gallagher.