Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 192

Harvard shows pitfalls of internal funds management

The decision by Harvard to terminate half of its investment staff and outsource funds management bucks the global trend to internalise funds management. The underperformance achieved in the past decade came despite Harvard having all the factors necessary to recruit and retain excellent fund managers. Harvard has a great brand name, patient and substantial capital to invest, and a willingness to recruit and pay for the best talent yet internalisation failed. Given this, is internal management the sure thing many claim?

Why internal management is so popular

The primary reason internalisation has taken off is that many fund managers are awful. They fail to outperform after fees, they communicate poorly and their products do not suit their clients’ needs. Given how poorly institutional investors have been treated, it is no surprise that internalisation, index funds, and ETFs have all grown substantially. These take market share and fees away from active managers.

Yet the blame for this cuts both ways. Many fund managers are poor because they have been allowed to get away with it. Many institutional investors and their asset consultants have opposed a more competitive industry and failed to redeploy capital to managers who would do a better job. By failing to advertise mandates and locking out emerging managers who would deliver better outcomes, capital allocators have unconsciously chosen to be treated badly.

In theory, internalisation holds out the promise of fixing these problems. By employing fund managers directly, fees can be lower and institutional investors can have more control and flexibility over their capital. If great fund managers are hired, alpha will be generated. Top-notch fund managers will be attracted to working for an internal team as they will no longer need to spend time on the laborious task of fundraising. The logic is so simple, yet Harvard has shown that it is far easier said than done.

Where Harvard went wrong

Harvard forgot several of the brutal realities the industry has proven over time.

In most asset classes, generating alpha after fees is difficult. A few exceptions in Australia are small capitalisation shares and credit, which both have substantial information gaps that hard-working fund managers use to create sustainable, long-term alpha. In highly competitive, information-rich sectors such as large capitalisation shares, private equity and hedge funds, managers as a group are taking most of the alpha generated.

There are a small number of truly great fund managers and these people generally often set the terms on which they work. They are generally closed to new capital and in some cases are returning capital.

Getting great talent to manage your money requires a similar set of skills to that of a great fund manager. You must work hard to find the best opportunities, monitor existing positions and free yourself from as many distractions as possible to remain successful.

Brutal realities ignored

There’s often a naivety among capital allocators that these brutal realities won’t apply if they internalise fund management. Capital allocators ignore the roadblocks that stop them building successful internal teams, such as:

  • Setting up internal teams targeting areas that have little or no net alpha. Why go to the effort and expense of targeting large capitalisation shares, private equity and hedge funds which can easily and very cheaply be replaced by an index fund or ETF?
  • Being unwilling to pay sufficient incentives to attract and retain the best talent. If an internal fund manager is substantially beating an index there is good reason to pay them 5-10% of the outperformance. If they are paid many times more than the CEO that reflects their greater contribution to the financial outcomes.
  • Taking away discretion on investment decisions and loading up fund managers with administration and office politics. These will detract from their investment performance and job satisfaction, making an internal environment a less appealing place to work than a boutique fund manager.

Don’t forget the cultural differences

Proponents of internalisation often forget that fund managers can have a different work culture. Fund managers that think and act the same as others are almost guaranteed to underperform. Some are eccentric or egotistical and likely to clash with a more bureaucratic culture. Requests for perfunctory reporting and attendance at general meetings may be ignored. Such actions can have a debilitating impact on staff morale. It’s also forgotten that when things go badly wrong, it is easier to terminate a fund manager than an employee.

Internal and external aren’t the only choices

It’s tempting to see internal and external funds management as the only choices, but they are simply two ends of a spectrum. Between these positions is a range of options that can lead to better outcomes. Some capital allocators have set up external teams, which share compliance, legal and HR functions but have separate offices and a clear mandate. Others have seeded new managers, or bought part or full stakes in existing managers. Some capital allocators give their fund managers broad mandates, allowing them to be opportunistic in allocating capital within or across several asset classes.

Another strategy is to reduce the number of managers used, with low-alpha sectors indexed, leaving more time for deep relationships with managers that can generate meaningful alpha. These deeper relationships benefit both parties with capital allocators getting higher returns, lower fees and a rich source of insights that informs their investment decisions. Trust is built such that fund managers can make the call that there isn’t value in one area and know that they will be given the opportunity to redeploy capital to another area with better value.

Sometimes you just have to ask to get what you want

For many capital allocators, the pathway to better outcomes isn’t to internalise but to change the managers they have. It is common business practice to run a competitive tender for the provision of services, yet capital allocators rarely do this. They largely eliminate the competitive tension that a public tender would create. Even worse, many capital allocators and asset consultants refuse to take meetings with managers that have higher returns and lower fees than their current managers.

This raises the issue of whether the underperformance problem is mostly due to capital allocators rather than fund managers. Before investment committees sign-off on internalising funds management, they should ask whether existing staff are doing a good job at picking managers. If the existing staff don’t know how to discover, select and negotiate with high-performing fund managers, what chance does a capital allocator have of finding and selecting these same people to work for them internally?

Conclusion

Internalising funds management is a growing trend, mostly in response to the poor performance of many fund managers. However, before signing off on internalising funds management, capital allocators should consider whether their existing staff are willing and able to select great fund managers.

 

Jonathan Rochford is Portfolio Manager at Narrow Road Capital. This article has been prepared for educational purposes and is not a substitute for tailored financial advice. Narrow Road Capital advises on and invests in a wide range of securities.

RELATED ARTICLES

Does Barrenjoey hold the key to Magellan's fortunes?

Five reasons fund managers don't talk about skill

Five features of a fair performance fee, including a holiday

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

US election implications for investors and Australia

The return of Donald Trump to the US presidency brings the prospect of more US tax cuts and deregulation, but also more tariff hikes, trade wars and policy uncertainty. Here's what it means for markets going forward.

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Taxpayers betrayed by Future Fund debacle

The Future Fund's original purpose was to meet the unfunded liabilities of Commonwealth defined benefit schemes. These liabilities have ballooned to an estimated $290 billion and taxpayers continue to be treated like fools.

The rising tension between housing debt and retirement balances

Australians are taking more mortgage debt into their 60s than ever before. Retirement planning assumptions haven’t adapted and could result in future income projections that ultimately disappoint retirees.

Latest Updates

Shares

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

Superannuation

Addressing the gender super gap

The harsh reality is that most women retire with significantly less superannuation than men. There are many reasons for the gender super gap and here are some possible solutions to fix the long-running issue.

Superannuation

Meg on SMSFs: Where are the risks in our major super sectors?

Given the amount of money in super, it’s not surprising that there is a lot of focus on risk. SMSFs are often portrayed as the riskier option for the community as a whole, but does that tell the full story?

Superannuation

Global pension reforms and how Australia can improve

With plans to retire next year, Mercer's David Knox looks back at the global pension index he helped create, the key trends and developments since inception, and what Australia can to do to get better.

Shares

Cyclical stocks will drive markets higher in 2025

Magellan's Head of Global Equities, Arvid Streimann, thinks that although stock price momentum will slow next year, cyclical companies will lead the pack. He outlines the risks to his forecast and the stocks he likes best.

Economy

How this GDP per capita recession compares to history

GDP was 0.3% for last quarter but the real story is this was Australia’s seventh consecutive quarter of negative GDP per capita growth. How does this economic drought compare to past ones, and what can we expect in future?

Investing

The mispriced investment opportunity in global defence

Markets benefitted from peace for 40 years, but a military resurgence is now underway, fuelled by geopolitical tensions and technological advancements. Defence spending is soaring, offering potential opportunities for investors.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.