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How to make in-house investment management work

In-house investment management is a hot topic in the Australian superannuation industry. Organic growth and industry consolidation mean many funds are attaining a size at which managing their investments in-house becomes a serious proposition. SuperRatings data reveals that about 60% of superannuation funds manage some assets in-house, with nearly one-fifth reporting a substantial commitment of 20% or more of assets.

Why does in-house management matter?

Managing assets in-house aligns with the policy agenda of improving the efficiency of the superannuation industry. Managing in-house, rather than contracting out to external investment managers, can not only reduce investment expenses for larger funds. It can also provide opportunities to access additional returns, tailor the portfolio towards member needs, and address capacity constraints as funds under management grow. It helps funds address the problem that active managers are only able to handle mandates up to a certain size. Thus, in-house management can invest in ways that not only enhance member outcomes, but are also more scalable and hence better able to accommodate asset growth and perhaps consolidation.

A natural progression

The shift to in-house management can be seen as a natural extension of historical trends. Traditionally, most superannuation funds have been outsourcers: initially of the entire investment process to a balanced manager (the 1980s model); then later by appointing specialist external investment managers, often under advice from asset consultants (the 1990s model). The construction of multi-manager asset portfolios, oversight of cash and currency management, and active asset allocation has required the creation of internal investment management teams. Indeed, much of the activity around in-house management can be traced to funds putting in place internal teams that possess the skills and confidence to directly manage the assets.

Examining the how and why

The 2016 CIFR study In-House Investment Management: Making and Implementing the Decision explores the contrast between the traditional model of outsourcing to external investment managers and in-house management. The research includes field interviews with 20 senior industry executives from superannuation funds, asset consultants, and research houses.

The motivations to adopt in-house management are varied, including:

  • return impact
  • capacity considerations
  • governance structures
  • alignment and culture
  • ability to attract, retain and incentivise experienced investment professionals
  • risk management

Each participant in the research seemed to have a different approach to deciding whether assets should be managed in-house. Some believe that in-house management can provide access to higher returns, while others expect gross returns to fall, but net returns to increase because costs will fall even further. Some consider the ability to tailor investments to be of prime importance, while others argue that tailoring can be effectively achieved using external managers. Some perceive staff management and culture as major challenges, while others think that these problems can be solved by targeting culturally-aligned staff. Some view systems as critical and a significant source of risk, while others trivialise the difficulty of establishing reliable systems. There is little industry-wide consensus.

There are some common elements in how in-house management is being addressed. All participants approach the decision on an asset-class-by-asset-class basis. They recognise that in-house management may not work for all assets or strategies. Cash is often the first candidate for managing in-house, given that investing in cash is relatively straightforward, can be implemented with modest resources, and has complementarities with fund liquidity management. Beyond that, there is only limited consistency across superannuation funds on what assets they prefer to manage in-house.

Structuring options

Four broad approaches for structuring in-house management were encountered during the interviews:

  • Dedicated internal structure, where an asset class is managed entirely in-house
  • Hybrid external/internal models, under which the in-house team is responsible for a slice of the assets in conjunction with external managers
  • Co-investments, where the fund piggy-backs on the ability of an external manager to identify and source assets through taking a ‘slice on the side’ and
  • Partnerships, either between funds or with an external manager, involving the fund providing capital while some management functions are performed externally.

The hybrid model appears popular in Australia, especially in core listed assets like equities and fixed income. Within the hybrid model, there is a further choice regarding the degree to which the in-house capability is segmented and treated as just another manager within the portfolio; versus being integrated and used to ‘complete’ the portfolio in some way. The hybrid model also raises the issue of respecting the intellectual property rights of external managers: again, there is a variety of views.

CIFR’s input: A decision framework, and some views

The study presents a framework that asset owners like superannuation funds might use for making and implementing decisions to manage in-house. It addresses four elements: capabilities, costs, alignment and governance. It weighs up the potential impact on net returns along the way, each with a checklist of potential aspects for consideration.

Based on the research, CIFR is generally supportive of in-house management, with the caveat that the conditions must be right for the fund, and that it needs to be implemented appropriately. Done properly, in-house management can generate improved net returns with increased control, allowing assets to be managed in a way that is better directed to member needs and delivered with greater confidence. It establishes a platform for the future, if designed as scalable and flexible. However, integrated hybrid models still have merit. These structures allow the portfolio to be managed in a manner that can enhance returns while supporting tailoring and flexibility, yet retains many of the self-disciplinary benefits of having external managers within the structure.

Some mistakes will inevitably be made by funds who manage in-house. However, fear of error should not prevent in-house management from being embraced where benefits are evident. In-house management is rarely of sufficient size to ‘sink a fund’ in its own right, as it typically occurs as discrete strategies across a range of asset classes. Rather, it is investment functions that cut across the entire portfolio – such as asset allocation and currency management – that carry more inherent risk.

Looking forward

The trend towards greater in-house investment management by superannuation funds has much further to run, driven by industry and fund growth, competitive tensions and innovation. The pioneering and successful efforts thus far provide encouragement. While members should benefit on balance, some bumps and set-backs are to be expected along the way. One interesting issue is the impact on external managers – their pricing, product offerings and engagement – given that they are facing the rise of a powerful new player on their turf: their former clients, the asset owners.

 

Geoff Warren is Research Director at the Centre for International Finance and Regulation (CIFR). The study, In-House Investment Management: Making and Implementing the Decision, is co-authored by Geoff Warren, David R. Gallagher and Tim Gapes, from the CIFR.

 

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