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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?


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.


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