Internal vs. External Management

Ashby Monk

There is a widespread debate among large sovereign funds and public pensions about whether to in-source asset management to internal teams or to outsource to external fund managers. I don’t personally have strong views either way. On the one hand, I can understand why a sophisticated institutional investor, such as the CPPIB, might like to bring assets in house to save on asset management fees, avoid agency issues and better align the interests of portfolio managers with the organization. On the other hand, I can also see the potential pitfalls of trying to run a sophisticated asset management operation in-house and, equally, I have genuine respect for those funds that focus their governance budget on becoming a highly sophisticated, outsourced institutional investor, e.g. the Future Fund.

Still, I am keenly interested in understanding how funds decide whether to insource or outsource. And, interestingly, this recent report by the California State Teachers’ Retirement Fund (CALSTRS) offers incredible insights into this decsion-making process. Here are the three main factors that determine, for CALSTRS at least, when an asset class should be brought in-house or left to external asset managers:

“When it comes to deciding whether to implement a strategy internally or externally, some of the factors that are generally considered include the following:

Transparency and liquidity of the underlying markets – While it appears that the internal versus external management debate centers around the public (i.e., fixed income and equity) markets as opposed to the private markets (i.e., private equity and real estate), it is really the transparency and liquidity of the markets within which each strategy trades that is the primary decision factor. Private equity and real estate are uniquely active markets, in which expertise in terms of property or company type, leverage, deal structure, deal components and terms make them truly active investments requiring resources capable of reviewing the fundamentals of the deal structure. Public equity and debt markets are more transparent, have broadly and widely recognized indexes, are highly liquid, and are amenable to structuring a broadly diversified portfolio. This liquidity and transparency, in terms of widely followed market information and pricing, make equity and fixed income portfolio management a different kind of management challenge, as the assets are broadly available for purchase and sale to all with a mandate and the proper business infrastructure/resources.

Cost effectiveness – One of the primary drivers, from an internal management point of view, is based on the argument that internal asset management has a lower cost structure than external management. This issue was touched on in a study last year in which staff compared the active versus passive implementation decision. Findings from that study showed that using internally developed expertise does in fact cost significantly less than external management. The argument for external management, while being more expensive, rests on the primary supposition that in order to obtain any sort of financial expertise (whether it be passive or active) the investor needs to pay the associated costs of the strategy and the fiduciary liability that the external manager must bear.

Risk management – This factor broadly applies to the infrastructure needed to manage a successful investment management business. It includes proper staffing levels, computer support systems, specialized software and, more importantly, highly specialized and skilled individuals who are well versed in the strategy(ies) being pursued and willing to take and manage risk within Policy and predetermined investment guidelines. Within internal asset management there is the potential for key staff members to leave for the private sector or another governmental fund, either based on working conditions or pay levels. External managers are paid based on either a flat or performance-based fee. Staffing and pay levels of the manager are left up to the manager. However, staff changes and key personnel leaving a firm can hurt investment performance and cause expensive and frequent transitions of managers for a fund that is more externally oriented. It has also been argued that internal management allows greater control over corporate governance issues, permits better coordination over when and how assets are deployed, and allows for a more straightforward mechanism to customize investment mandates that align with a plan sponsor’s directives. With internal management, the Board makes these decisions and places decision making authority with the Chief Investment Officer (CIO) and individual Directors, who then implement strategy through Portfolio Managers and Investment Officers. In contrast, external management eliminates the need for these decisions, as the decision to hire and fire a manager can rest with the CIO. As a result, there are fewer concerns about staffing, investment responsibility is limited to the external manager, and internal staff is responsible for the smooth integration of the manager into the master custodial process and determining the manager’s fit into the overall portfolio structure, rather than being involved in day-to-day oversight of portfolio holdings and transactions. However, external expertise is typically more rigid in terms of adjusting investment practices and/or approaches to meet specific client objectives. As a result, external management typically requires an incremental level of negotiations to meet an objective compared with internal management.”

I have to say. That seems like a pretty sensible way of thinking about the internal / external decision.

5 Responses to “Internal vs. External Management”

  1. 1 Investor March 16, 2011 at 9:31 am

    The CALSTRS decision criteria isn’t quite up to snuff in real practice.

    Re transparency and liquidity: Just because it appears that you have transparency and liquidity doesn’t necessarily mean that you have transparency and liquidity. Case in point? Mortgage backed securities. Transparent and liquid — according to Moodys, Greenspan and Bernanke as well as a few Goldman sales people. Not so transparent and liquid in practice. Re private equity: The difference lies not so much in that they’re investing in illiquid, private (seemingly not transparent) but that they have consummate deal making skills. While most non sophisticated investors would equate those skills to buying a car, in practice, doing a multibillion dollar deal is much harder and much more complex. Also in practice, buying a well-vetted company in a private transaction actually gives you *more* information than a public stock. If you’ve ever taken a look at a private offering memorandum, you’ll know what I mean.

    Re costs: Maybe, but you may also get what you pay for.

    Re risk management: External managers leave all the time so what’s the difference here? What you really want to look for here is how do managers handle tail risk, i.e. the unforeseen.

    What may be much more operative in practice is understanding what incentives SWFs have to outsource or insource, i.e. their personal compensation.

  2. 2 Ashby Monk March 18, 2011 at 12:02 pm

    These are really good points. And on the PE side, I totally agree (having worked in PE in my youth…the due diligence process gives you a ton of info that you won’t get in public equities). Thanks!

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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