Weekend Reading

Ashby Monk

The two articles below are to be read from the comfort of some sort of floating-type pool chair; preferably the kind with a place for ‘cold drinks’ in the armrest:

First, I just came across a really useful paper by Bauer, Cremers and Frehen from 2010 entitled “Pension Fund Performance and Costs: Small is Beautiful”. It’s quite interesting, as it offers some useful data on the cost and performance of domestic equity investments by US pension funds. In addition, it expands the ‘in-source v. outsource‘ debate that has been taking place among many large institutional investors. Here are some highlights:

“Irrespective of fund size, externally managed mandates are found to be significantly more expensive than their internally managed counterparts.”

However, the authors go on to say:

“In general, we find some evidence suggesting that external management performs slightly better, with the difference being smaller for the largest internally managed mandates…This is consistent with investments requiring a certain size in order to be able to build sufficient expertise and profitably keep management in-house.

“In conclusion, we argue that pension funds perform close to their benchmarks in the aggregate, and on average outperform in smaller funds and mandates and in small cap mandates. We find some evidence for scale advantages in internally managed portfolios and in bargaining power with external parties.”

In sum, if you don’t have the necessary skills, capabilities and governance to manage assets in-house, you’re far better off outsourcing (at least for this one asset class). I agree.

Second, readers of this blog know that I’ve taken an interest in infrastructure. Why? Well, I think long-term investors, such as sovereigns, have a unique opportunity (and affinity) to make money in this asset class. Infrastructure assets can offer economies of scale, inelastic demand, stable cash flows, uncorrelated returns, inflation linkage, and downside protection. Moreover, the high barriers to entry don’t pose too big a problem for SWFs. And while liquidity is generally a cause for concern, it shouldn’t be an insurmountable problem for a fund that can hold an investment for the life of the asset.

However, for a variety of reasons, most long-term investors, and in particular SWFs, are underweighting this asset class. Therefore, I view it as an interesting and useful conceptual project to ponder and develop new structures and governance mechanisms that will facilitate SWF investment in this asset class. (In part, this is why I’ve also become interested in internal investment programs, because it seems to make the most sense in these extremely long-term, illiquid asset classes.)

Anyway, all this is to say that infrastructure investing is intriguing. So, you should check out this new paper by ‘The Christophs’ (Rothballer and Kaserer) entitled “Is Infrastructure Really Low Risk? An Empirical Analysis of Listed Infrastructure Firms.” Here’s a blurb:

“Over the past decade infrastructure has gained increasing investor attention spurred by the conviction that it provides low-risk returns. However, empirical evidence on the actual risk characteristics of infrastructure investments is limited…Yet, as there are large variations within the infrastructure asset class, the low risk hypothesis cannot be maintained for all sectors. In contrast to the widespread be- lief that total corporate risk is lower for infrastructure firms, we observe that infrastructure stocks across all sectors exhibit a similar volatility as non-infrastructure stocks. Hence, infrastructure is characterized by significant exposure to idiosyncratic risks despite the low competitive pressure in infrastructure industries. This peculiar risk profile can be partly explained by construction risks, high operating leverage, the ex- posure to regulatory changes, and the lack of product diversification. This finding highlights the need for diversified infrastructure portfo- lios, advanced risk management capabilities and efficient risk sharing mechanisms between the private and the public sector.

Have a nice, albeit very hot, weekend!

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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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