Australian superannuation funds are increasingly aiming to achieve their investment objectives by managing assets in-house, thereby reducing their reliance on external investment managers. Some industry observers presume this trend is primarily driven by pressure to reduce costs. They also worry that lower investment returns will wipe out the few basis points saved on external management fees.
Many of their concerns relate to the notion that managing assets has traditionally not been a core business for superannuation funds. They fear that funds could struggle to attract and retain skilled staff in the competitive investment industry, and fall foul of the governance, systems and cultural challenges involved in running investment teams. But is this a fair characterisation?
The Centre for International Finance and Regulation (CIFR) has examined a range of issues surrounding the trend towards greater in-house management through interviewing superannuation industry executives. We uncovered a fair amount of agreement over the key areas that need to be considered, but substantial diversity of opinion around how the decision should be approached and what aspects deserve the most emphasis. Nevertheless, it was clear that the drivers of in-house management go well beyond the potential to reduce costs. Other influences include capacity constraints, alignment and tailoring; exploiting competitive advantages from owning assets directly; and gaining market insights from being active in the markets. In addition, we found reasons to believe that concerns over the risks may be overdone.
Range of benefits
It is true larger funds are able to save on costs by bringing assets in-house. This is achieved by converting a variable management fee to a fixed cost of lesser magnitude. Nevertheless, constraints on the mandate size that external active managers can accept are at least equally important. Once assets reach a level at which a fund’s existing external managers are capped out, it is faced with three options: adding more managers, introducing a passive core, or building a (scalable) in-house capability to manage a slice of the assets. The in-house option is often seen as the most attractive from a cost–benefit perspective.
An in-house capability also offers the advantage that it is solely focused on meeting the fund’s objectives. Tailoring benefits were mentioned by 90 per cent of our interview participants. In addition, some view in-house management as offering scope to enhance fund returns through increased flexibility to grasp opportunities as they arise, or perhaps to invest with a longer horizon. In contrast, external managers are rewarded for beating their benchmarks and attracting new assets. As a consequence, they may overlook opportunities where pay-offs may not be immediate.
Risk concerns overrated
While managing in-house does indeed come with its challenges, our interviews brought to light reasons to believe that the risks are both manageable and non-critical.
First, in-house management is being undertaken on an asset class by asset class basis in a measured, forward-looking and incremental fashion. It mainly occurs in small, mostly unrelated pockets across the fund, with different teams assigned to various asset classes. The chance of one of these units “blowing up a fund” by itself seems remote.
Second, most funds have designed strategies to mitigate the risks. Many aim to meet the challenges related to staffing and cultural tension by employing culturally aligned staff in the first instance. The issue here is whether there exists a sufficient pool of skilled and potentially aligned investment professionals, who are willing to accept lower remuneration for an opportunity to focus on just managing money at a not-for-profit fund. This seems plausible. Assurance around governance, systems and the capabilities of in-house teams might be obtained through commissioning regular external reviews of performance and structures. The dangers of becoming overdependent on an in-house team can be limited by retaining external managers in the mix.
Building a platform for the future
The CIFR is generally supportive of in-house management. We started off as sceptics, being worried about the risks. However, we came around to the view that these risks can be managed and that, done properly, in-house investment management is capable of improving net returns with enhanced capacity to manage assets in a manner that is better directed to meeting member needs. A scalable and flexible in-house capability can also establish a platform for the future. Greater use of in-house management seems inevitable as funds become larger due to superannuation industry growth and consolidation.
Dr Geoff Warren is research director at the Centre for International Finance and Regulation.