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

Large super funds struggle to match index in Aussie equities

You get what you don’t pay for

The opportunity cost of low fee structures

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Let's make this clear again ... franking credits are fair

Critics of franking credits are missing the main point. The taxable income of shareholders/taxpayers must also include the company tax previously paid to the ATO before the dividend was distributed. It is fair.

Welcome to Firstlinks Edition 424 with weekend update

Wet streets cause rain. The Gell-Mann Amnesia Effect is a name created by writer Michael Crichton after he realised that everything he read or heard in the media was wrong when he had direct personal knowledge or expertise on the subject. He surmised that everything else is probably wrong as well, and financial markets are no exception.

  • 9 September 2021

Latest Updates

Investment strategies

Joe Hockey on the big investment influences on Australia

Former Treasurer Joe Hockey became Australia's Ambassador to the US and he now runs an office in Washington, giving him a unique perspective on geopolitical issues. They have never been so important for investors.

Investment strategies

The tipping point for investing in decarbonisation

Throughout time, transformative technology has changed the course of human history, but it is easy to be lulled into believing new technology will also transform investment returns. Where's the tipping point?

Exchange traded products

The options to gain equity exposure with less risk

Equity investing pays off over long terms but comes with risks in the short term that many people cannot tolerate, especially retirees preserving capital. There are ways to invest in stocks with little downside.

Exchange traded products

8 ways LIC bonus options can benefit investors

Bonus options issued by Listed Investment Companies (LICs) deliver many advantages but there is a potential dilutionary impact if options are exercised well below the share price. This must be factored in.

Retirement

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Investment strategies

Three demographic themes shaping investments for the future

Focussing on companies that will benefit from slow moving, long duration and highly predictable demographic trends can help investors predict future opportunities. Three main themes stand out.

Fixed interest

It's not high return/risk equities versus low return/risk bonds

High-yield bonds carry more risk than investment grade but they offer higher income returns. An allocation to high-yield bonds in a portfolio - alongside equities and other bonds – is worth considering.

Sponsors

Alliances

© 2021 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. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.

Website Development by Master Publisher.