My morning ritual of drinking an unseemly amount of coffee and then scouring the interwebs for any and all Giant-related news unearthed something rather interesting: Four separate stories about large institutional investors shifting assets away from external managers and giving them to internal teams of direct investment professionals. Here they are:- This story highlighted the many superannuation funds in Australia that are moving towards a greater proportion of in-house investing: Like many other large investors around the world, some are enticed by the idea of bringing capability in-house... - This article shows how the Abu Dhabi Investment Authority has been shifting its resources from external managers to in-house teams, even boosting its staff to 1400 (!) in order to support its in-house initiative. - This article shows that the Alaska Permanent Fund Corporation is laying the groundwork to begin in-sourcing three major strands of its investment capability. - Finally, the $40 billion Teachers' Retirement System of the State of Illinois also announced plans to remove some of the intermediaries in its investment production chain. This may be displeasing to the tax-men and -women of the global economy, who tax all the exchanges between savers and entrepreneurs... err, sorry... I mean to say: This may be displeasing to the finance professionals of the world, who help to efficiently allocate resources around the complex global economy. Why? Because the big and boring institutional investors of the world that used to rely on their services are becoming, well, less boring and more self-reliant. And I not only think this is a good thing... I think its the future of finance. As Ive argued before, I believe many of the problems with our system of capitalism are driven by the fact that our pensions, sovereigns, and other long-term investors arent highly sophisticated. Direct investing is a mechanism to drive professionalization and sophistication. (The more you know, the more you know you don't know... you know?) Research also shows that in-house asset management can lower costs and generate higher net-of-fee returns for large investors. As you can see, then, its natural that more institutional investors are doing this. The problem, however, is that its very, very hard to do... which is why Ive been so busy doing research projects on this topic for the past four years or so. (See here, here, here, here, here oh and here and this is important too.) In sum, this is a topic I'm passionate about and, unlike most of the articles I write, I may be able to actually move the debate forward. So, let me leave you with two pieces of information that I think every would-be in-sourcer should have before going down the path of direct investing; this will come in the form of a warning and a road map. 1) A Warning: As I said in a recent paper, The operational DNA of a traditional, externally managed institutional investor looks completely different and is set up with different objectives than the operational DNA of an internally oriented institutional investor. Going direct thus requires an overhaul of many of the existing institutions and processes; which means in-house asset management is much more difficult to implement than just hiring a few dealmakers. It requires mobilizing significant internal resources and committing them to a specific course of action. 2) A Roadmap: In the same paper, Gordon Clark and I... ...develop a series of principles and policies to guide Boards in their in-sourcing journey. At the highest level, we conclude that governance is the key touchstone to a successful in-house investment capability. In our view, the Board holds the strategic levers of success for institutional investment organizations. As such, it is the Board that will help develop the following nine elements of in-house asset management: - People: The Board has to understand the importance of people and be willing to offer compensation packages sufficient to get the talent required, keeping in mind that even generous compensation paid to internal teams will almost always be dwarfed by the compensation routinely paid to external managers. - Organization: A Board must have final authority over the allocation of resources and work to develop all aspects of the organization. - Risk: Given that investors are little more than risk managers, operational and financial risk management is crucial. Note that the risk management function should not prevent the dynamic capabilities that can lead to success. - Culture: Developing in-house asset management capabilities requires creating a culture of risk taking that is not present in most externally oriented institutional investors. - Assets: No institutional investor can or should do everything in-house, which means that the Board must be very careful in selecting where the fund begin and focus its in-sourcing efforts. - Mandates: Internal mandates should be conceptualized, sold and launched with the same rigor demanded of external managers. - Delegation: Successful in-sourcing requires delegation to experts and segregation of duties to ensure that these experts are being held accountable for their actions. - Communication: A long-term investor with in-house operations has to be pro-active with its stakeholder outreach to ensure the ongoing legitimacy of the fund, even when markets are not cooperating. - Networks: Successfully executing an in-house strategy almost certainly requires developing a network of like-minded peers to share opportunities and experience.
As this highlights, the path to move asset in-house is a long and difficult one. As such, it is important to be extremely selective in the areas where the fund looks to add value through in-sourcing and be humble about whats possible. Institutional investors considering internal mandates should always look to the market first to see if the service can be purchased at a lower price (with comparable returns) than the internal teams. If a fund can do no better than anybody else, it should outsource it to those people and focus efforts on something else.