To see this article in digital magazine format, click here.
Remember when we used external third-party asset managers? What were we thinking? This might not be widely prominent across Europe yet, but growing disillusionment with third-party fund managers, consultants, and other service providers has meant large investors are moving an increasing level of expertise in-house—and the trend seems to be speeding up.
In May, United Kingdom (UK)-based grocer and general retailer Tesco revealed it had lifted several fund management staff from fund giant Legal & General Investment Management to run an in-house pension team. The fund has around £6 billion and is one of the few large, defined-benefit pension schemes that remain open to all staff in the UK. At the time, Lucy Neville-Rolfe, executive director at Tesco, said: “We are building a high-calibre in-house team to help manage our growing scheme and reduce dependence on external providers.”
Tesco is not alone. Most of the largest European pension funds have an established core investment team, and they have begun to actively add to this capability. “We are seeing a growth, or resurgence, in internally managed pension funds across Europe, not just in the UK,” says Mark Johnson, managing director (UK strategic clients) at BlackRock. “There are clear benefits to the alignment of interests of the in-house model and it is cost efficient.”
Others agree. “Internal teams are being beefed up and there is increased specialism within them, which highlights the recognition of the complexity involved with current investment strategies and the necessary resources that go with it,” according to Heath Mottram, head of fiduciary management (UK) at the consulting arm of Russell Investments. “But if you are going to build an in-house team from scratch, you will probably need at least a hundred people to successfully cover all the bases and that is well beyond most institutional investors.”
Beyond most, yes—but not all.
“It is happening; there is a trend to move investment management in-house,” according to Richard Moon, investment manager for alternatives at £18 billion RailPen Investments, which established an internal team well over a decade ago. “Some of the larger funds are building direct teams—private equity and infrastructure—internally. At the very least they are building “manager of manager” structures internally. Most of them are doing it to reduce costs, but it does allow the fund more control over portfolio construction.”
This control extends to getting authorization from the UK regulator—the Financial Services Authority (FSA)—to become actual third-party managers, which allows the investment team more nimbleness. “Some have gone for FSA-approved status, which reduces the requirement (under the Pensions Act) to seek advice from third parties before making investment decisions, and therefore can respond much more quickly to opportunities and changes in the financial environment,” says BlackRock’s Johnson.
Tesco has obtained this approval—and others are doubtless preparing to jump through the regulatory hoops in order to do the same—as there are clear cost efficiencies and alignment of interest that is almost impossible with a third-party manager. “There are two basic drivers behind bringing investment management in-house: cost and alignment,” says the well-respected industry veteran Roger Gray, CIO at the Universities Superannuation Scheme (USS). “Depending on the scale of the fund and the nature of its allocations, it may make sense to have an internal team.” USS, one of the largest pension funds in the UK with approximately £33 billion in assets, has a well-established internal team that invests in a range of alternatives through an impressive line-up of staff. Gray, who joined the fund in 2009, added: “It’s not an ‘all or nothing’ decision. But some element of control at the center of the fund, to take asset allocation for example, is generally useful. Also some funds will be able to manage liquid assets, such as UK equities, but a fund has to be relatively big like USS to justify covering a broad waterfront internally.”
Setting up these institutions is not cheap, however.
“Insourcing all investment activity is an option for only a tiny minority, but for the very large ones it could be perceived as cheaper than using external providers who are looking to make a profit,” according to Russell’s Mottram. “However, the cost of setting up these teams with all the trading capabilities for a closed fund with a finite time horizon would just not be worth it. Nor would they be able to attract good people with a long-term career view.”
But there are benefits for some to having an in-house team.
“Alignment between fund interests, career, and compensation can be high within internal managers, with longer-term incentives on an after-cost, risk-adjusted basis,” says USS’s Gray. “Some third-party managers are willing to accept longer-term performance incentives—on a five-year basis, for example —but this is not universal. In-house teams can also have an element of compensation linked to the performance of the whole fund, which aligns their interest more closely than for third-party managers.”
So where does that leave consultants and asset managers? Winning mandates from these giant funds can mean all the difference to their bottom line.
“Consultants are not out in the cold, but the relationship might be different,” says Pete Drewienkiewicz, head of manager research at consulting firm Redington. “This model favors firms with a smaller cost base that can be more agile.” Ciaran Mulligan, head of manager research at Buck Consultants, adds that with the internal model there would be less manager selection advice needed, but these investors would still often work with consultants when they needed strategic advice for example. Mulligan also says that “for fund managers it’s not cataclysmic either, but there are some who are doing a suboptimal job across a range of areas so there is certainly room for contraction and they can focus on where they can really add value for their investor clients.”
So is performance the bottom line for these teams? Star fund managers are not likely to switch to an in-house team run by a pension fund to work for a fraction of the salary and bonus they may be earning in a third-party manager. Is it worth losing the potential upside—presuming the current set of managers is achieving what they need to—for an in-house function?
Perhaps Gray puts it best. “With an internal team, do you end up with the best manager in the world?” he asks. “Probably not. But when you look at benefits—alignment of focus, goals, and the reduced costs that go with it—it is worth considering.”
And why stop there? If an internal team can manage assets with liabilities at the forefront of its mind, is it plausible to do it for others? After all, in the Netherlands, two of the country’s largest pension funds were broken up by the regulators, leaving the resulting fund management arms actively seeking third-party business in the sector.
“To consider marketing their capability to other pension funds, they would need a credible investment offering and be able to compete with services that already exist in the market place,” says Mulligan at Buck. “It is possible that they could do it, but it takes time to build up a track record and reputation. The market is already concentrated and this type of evidence would normally be needed.”
With the European markets in the current chaotic state, it may be better for these funds to concentrate on their own liabilities first before going after the responsibility for someone else’s—but there is definite movement. “There is a trend in the industry to internalize investments,” Gray says. “However, in the UK the pensions sector is very fragmented. If there was more consolidation of pension funds, such as we have seen in Holland, this could help pick up the pace of the trend.”
With the number of pension funds in the UK totalling tens of thousands, and noises in the sector suggesting consolidation may not be far away, this pace could pick up very soon indeed. This, combined with the trend toward asset owners becoming asset gatherers, should have the current plethora of existing asset managers and consultants worried.