Why home teams are winners
As the trend towards outsourcing continues to gather pace, and both external managers and investment consultants intensify their marketing efforts, internal managers must be feeling a little beleaguered. But they are sure to find some reassurance in the WM Company’s latest analysis of internal investment management in the UK pensions arena.
According to the report, internally managed funds have a lot going for them – not only do they outperform externally managed funds, but they do so from a lower cost base. They also have some structural advantages: they can take a longer-term view because they are not subject to short-term commercial pressures; their managers can be more focused because their attention is not divided among several clients; and they generally have excellent working relationships with their trustees.
WM did find that there has been a clear reduction in the number of internally managed funds. While in 1985 there were 54 funds under internal management, accounting for a 46% market share, in 2000 there were only 28, representing a market share of only 30% of the WM Pension Fund Universe. These account for 25% of the total UK pension fund market and had a combined market value of more than £158bn at the end of 2000.
Interestingly, the report points out: “…the number of funds has almost halved, yet the percentage share has only reduced by a third. This suggests that it was the ‘smaller’ internals which have defected”. Basically, internally managed funds tend to be large and mature – 82% fell into WM’s super-mature category, meaning that they have a maturity ratio (non-active member liabilities to total liabilities) of greater than 60%. The remaining 18% fell into the mature category, with a maturity ratio of between 40 and 60%. They were evenly split between being cash-flow positive, neutral and negative.
More than half of the internally managed funds in WM’s sample were corporate funds: these 15 funds accounted for around £93bn; six were public funds, accounting for more than £18bn; and seven were tied funds, accounting for £46.6bn.
The vast majority of the internally managed funds surveyed handled at least 80% of their assets in-house; in fact, two-thirds managed the total fund or more than 90% of the fund’s assets. The average number of managers per fund was eight, but the number did range from two to 20.
Two-thirds of the funds were involved in managing equities, evenly split between UK and overseas; only 14% managed bonds; and the rest were divided among various other asset classes. Practically all the funds managed their bonds internally.
While the asset mix of internally managed funds was broadly similar to that of externally managed ones, they did tend to have a slightly higher proportion in equities – around 3% more – and a correspondingly lower proportion in index-linked investment. The internally managed funds generally managed their equities on an active basis: WM found that only four of the 28 funds had a significant portion that was passively managed.
The report did turn up significant differences in the way the active management is handled. The internally managed funds had an average of 212 active stocks in their portfolios (the range was between 75 to 338), which is significantly higher than the number held in an externally managed fund. However, activity levels were markedly lower.
Take UK equities as an example: while internal funds registered a 31% average portfolio change during 2000, externally managed funds showed a 53% change. This kind of differential holds true for all categories of overseas equities, as well as for bonds. As the report points out, “in a year where activity levels were the highest recorded internally managed funds changed just under a third of their UK equity portfolio compared to over a half for internally managed fund. Lower trading activity leads to lower costs”. See table 1.
And this is not the only area in which costs are lower with internally managed funds. They also beat external funds on management fees, and this lower cost base is a major plus point. Fees ranged from 3 to 17 basis points, with fees for nearly half the funds (47%) falling between 6 and 10 basis points. For 29% of the funds, fees were less than 5 basis points, and only for 24% did they range between 11 and 20 basis points. This range is substantially more compact – and lower – than that for externally managed funds. As more and more funds are evaluated on a net-of-fees basis, this lower level of fees will represent a distinct advantage for internally managed funds. See chart 1.
But the proof of the pudding is in performance, and in this area the returns generated by the internally managed funds compare favourably with those of externally managed funds. WM’s analysis shows that internally managed funds added value not just through lower trading levels, but also through stock selection.
The report studied returns over three five-year rolling period, and it found that internally managed funds produced a tighter range and a higher average return for both UK and European equities over all three periods. For the UK, internal managers outperformed external ones by about 0.3% per annum; and for Europe, they outperformed by around 0.2% per annum.
The situation was different for other types of investment, however. For both Japanese equities and bonds, external managers produced better average returns, albeit with a wider dispersion.
Overall, accompanying the tighter dispersion of the internally managed funds is a lower level of risk (volatility of returns relative to their primary benchmark). Their tracking error (relative risk) is also substantially lower for internally managed funds, at 1.6% per annum. This compares with the median for external managers of 2.2 per annum. It also puts internally managed funds in the 75th percentile for externally managed funds – in short, internal funds are in the lowest quartile of risk. And as the report also points out, “While only 5% of internal funds have relative risk more than 3%, 25% of external funds have relative risk greater than 3% per annum.” See chart 2.
The internally managed funds do not achieve this lower level of risk by aiming low. Nearly all the funds aim to outperform their benchmarks. Nearly 40% are aiming for outperformance of at least 0.5% per annum, and more than 10% are looking to outperform by more than 1%. Some 20% simply aim to exceed the benchmark. Almost two-thirds (63%) have a fund-specific benchmark as their primary benchmark; 25% use their peer group as their primary benchmark. However, more than half use the peer group as their secondary benchmark (80% use the WM 50 Universe).
Only just more than one-third of the internally managed funds has a downside limit. The most common one is to be no worse than 1.5% below the benchmark, and this corresponds neatly with the fact that the most common added-value target is 0.5% (following the rule of thumb that the downside limit should be three times the added-value target).