Cost is the flagrant motivation in the trend for US pension funds to move assets in-house, but as this article explores, budgets also need to extend to the demands of investment research, travel and staff incentive compensation.
The $71.6 billion New Jersey Division of Investment (NJDOI) has been doing it for decades, and now other large public pension funds are assessing the cost advantages of managing assets in-house and debating the merits of the move.
Cost remains the key driver, and with NJDOI’s estimate that it has reduced its external investment management fees by $40 million, it is a pretty persuasive argument.
But investment budgets need to also cover the demands of investment research, travel and compensation, making the cost-effectiveness debate more complicated.
“New Jersey has found that internal management greatly reduces fees and expenses, and our performance still remains strong in comparison to benchmarks,” spokesperson at NJDOI, Andy Pratt, says.
Research by the Toronto-based CEM Benchmarking, has found that for every 10 per cent increase in internal management, net value added increased by 4.1 basis points on average. This was almost entirely due to the lower cost of internal management, and not a reflection of skill, as before costs the research found there was no statistically significant difference in gross value-added performance between internal and external management at the asset class level.
Of course one of the key advantages of external management is the depth of research and capabilities in investment management houses.
New Jersey – which manages 100 per cent of US equities, non-US equities and fixed income in-house – works around this by using research and data from Wall Street to inform investment decisions.
“The fund’s size makes us an important player in the market,” Pratt says.
“Our managers have noticed that the need for hiring outsider advisers on some types of investments has been greatly diminished,” he says.
“There is enough expertise in-house after a few years within an investment class to allow pension plans to either go without advisers or to spend less on advisory services.”
Competing with external providers in performance incentives is also a concern for institutional investors wishing to bring money in-house, and is a consideration the likes of OMERS in Canada, and CalPERS and Texas Teachers in the US have been deliberating.
New Jersey’s Pratt says a lack of compensation such as performance incentives, makes it harder to hire and keep the best managers who are often enticed to external services through offers of better pay.
State-based funds are often severely limited by state budgets – for example California is now on a hiring freeze – and restricted in their ability to provide adequate cost of travel and research which are needed to make informed decisions.
“State rules for travel and expenses are not designed with the needs of investment managers in mind,” says Pratt.
Of the largest funds in the US there is a wide range in the amount of assets managed internally and externally.
The Pension Fund Data Exchange’s October 2010 internal/external management data shows that two-thirds of funds manage at least 70 per cent of US equities internally, while in non-US equities most funds show a preference for external management. Fixed income is the asset class with the most internal management, with almost 50 per cent of the funds measured managing all of their fixed-income assets in-house.
New Jersey is the only fund to manage all US equities, non-US equities and fixed income 100 per cent in-house.
A comparison of performance of funds that manage internal and external assets raises some interesting points.
For example in US equities for FY2010 New Jersey, which manages assets totally internally, returned 15.8 per cent. (Overall the New Jersey fund has been a consistent high performer in the US.)
The $79.4 billion Washington State Investment Board (WSIB), which outsources the management of US and non-US equities but manages fixed income in-house, returned 16.8 per cent for US equities. While the external managent outperformed in this case, it was not disclosed if these returns were after fees.
CEM Benchmarking’s chief operating officer, Terrie Miller concedes there does not seem to be any real difference in returns between internal and external managers, rather it is cost that makes the difference.
“We haven’t found any real difference in returns between internal and external managers, of course there are always individual managers here and there who are kind of singular in their ability to beat the markets but on average, between the two groups there is no real difference,” she says.
The $228.2 billion CalPERS which manages more than 50 per cent of both US and non-US equities in-house is moving towards more in-house management, with the greatest shift from external to internal management occurring in global equity.
While reducing costs is an incentive – 90 per cent of CalPERS’ investment office expenses for FY2009-10 were external asset management fees (see story here)– the internal team is tasked with achieving the same beta as external managers, which according to CalPERS spokesperson Clark McKinley, too often were not producing alpha.
“We’re still ramping up staff for more active management and developing our information technology systems to allow more internal management. We’re talking about a process that will take the next few years,” McKinley says.
“We’re shifting to more active management by our own staff because we’ve found that external managers have given us beta but not alpha, but we’re still paying them management fees. It’s more cost-effective to manage those index funds by ourselves.”
Almost two-thirds of CalPERS’ assets overall are managed in-house, with only a little more than one-third with external managers.
While funds focus on cost benefits of internal and external management, there are other factors a fund needs to analyse when deciding on the best strategy.
“It’s not just about money,” CEM’s Miller says.
Miller says before considering whether to outsource or manage assets internally, a fund has to decide whether the assets will be managed actively or passively.
“They have to decide if they believe they can beat a market or not,” she says. “The first question the funds have to ask is can they actually make money by going active then they have to decide if they want to do that internally or externally – how much they can beat the market by and is it worth the cost?”
The transparency and liquidity of the underlying markets, risk management, talent and experience level of staff, and the statute of the particular state also play a role in the decision-labyrinth.
