Internal vs. External Managers

How do pension funds and SWFs decide?

March 17, 2011

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indecision road signThere is a widespread debate among large sovereign funds and public pensions about whether to in-source asset management to internal teams or to outsource to external fund managers. I don’t personally have strong views either way. On the one hand, I can understand why a sophisticated institutional investor, such as the CPPIB, might like to bring assets in house to save on asset management fees, avoid agency issues and better align the interests of portfolio managers with the organization. On the other hand, I can also see the potential pitfalls of trying to run a sophisticated asset management operation in-house and, equally, I have genuine respect for those funds that focus their governance budget on becoming a highly sophisticated, outsourced institutional investor, e.g. the Future Fund.

Still, I am keenly interested in understanding how funds decide whether to insource or outsource. And, interestingly, this recent report by the California State Teachers’ Retirement Fund (CALSTRS) offers incredible insights into this decsion-making process. Here are the three main factors that determine, for CALSTRS at least, when an asset class should be brought in-house or left to external asset managers:

“When it comes to deciding whether to implement a strategy internally or externally, some of the factors that are generally considered include the following:

Transparency and liquidity of the underlying markets – While it appears that the internal versus external management debate centers around the public (i.e., fixed income and equity) markets as opposed to the private markets (i.e., private equity and real estate), it is really the transparency and liquidity of the markets within which each strategy trades that is the primary decision factor. Private equity and real estate are uniquely active markets, in which expertise in terms of property or company type, leverage, deal structure, deal components and terms make them truly active investments requiring resources capable of reviewing the fundamentals of the deal structure. Public equity and debt markets are more transparent, have broadly and widely recognized indexes, are highly liquid, and are amenable to structuring a broadly diversified portfolio. This liquidity and transparency, in terms of widely followed market information and pricing, make equity and fixed income portfolio management a different kind of management challenge, as the assets are broadly available for purchase and sale to all with a mandate and the proper business infrastructure/resources.

Cost effectiveness – One of the primary drivers, from an internal management point of view, is based on the argument that internal asset management has a lower cost structure than external management. This issue was touched on in a study last year in which staff compared the active versus passive implementation decision. Findings from that study showed that using internally developed expertise does in fact cost significantly less than external management. The argument for external management, while being more expensive, rests on the primary supposition that in order to obtain any sort of financial expertise (whether it be passive or active) the investor needs to pay the associated costs of the strategy and the fiduciary liability that the external manager must bear.

Risk management – This factor broadly applies to the infrastructure needed to manage a successful investment management business. It includes proper staffing levels, computer support systems, specialized software and, more importantly, highly specialized and skilled individuals who are well versed in the strategy(ies) being pursued and willing to take and manage risk within Policy and predetermined investment guidelines. Within internal asset management there is the potential for key staff members to leave for the private sector or another governmental fund, either based on working conditions or pay levels. External managers are paid based on either a flat or performance-based fee. Staffing and pay levels of the manager are left up to the manager. However, staff changes and key personnel leaving a firm can hurt investment performance and cause expensive and frequent transitions of managers for a fund that is more externally oriented. It has also been argued that internal management allows greater control over corporate governance issues, permits better coordination over when and how assets are deployed, and allows for a more straightforward mechanism to customize investment mandates that align with a plan sponsor’s directives. With internal management, the Board makes these decisions and places decision making authority with the Chief Investment Officer (CIO) and individual Directors, who then implement strategy through Portfolio Managers and Investment Officers. In contrast, external management eliminates the need for these decisions, as the decision to hire and fire a manager can rest with the CIO. As a result, there are fewer concerns about staffing, investment responsibility is limited to the external manager, and internal staff is responsible for the smooth integration of the manager into the master custodial process and determining the manager’s fit into the overall portfolio structure, rather than being involved in day-to-day oversight of portfolio holdings and transactions. However, external expertise is typically more rigid in terms of adjusting investment practices and/or approaches to meet specific client objectives. As a result, external management typically requires an incremental level of negotiations to meet an objective compared with internal management.”

I have to say. That seems like a pretty sensible way of thinking about the internal / external decision.

This post originally appeared on the Oxford SWF Project website.

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