Internal managers take the laurels
An analysis of the UK’s internally managed sector by The WM Company
Internally managed funds have been a significant component of the UK pension fund industry for the last 25 years. The number of internally managed funds has fallen over this period having succumbed to the constant pressure from the external manager’s marketing effort and the investment consultants with their vested interest in promoting external multi manager arrangements. This article looks at the merits of the internally managed funds and answers the question “is there still a place for internally managed within the UK Pension fund market”?
We identified 19 corporate pension funds in the WM Universe of UK Pension Funds at the end of December 1998 where the majority of the assets were managed on an internal basis. These funds had a combined market value of £108.2bn. This represented 22% by value of the WM Pension fund Universe. In addition there were also seven ‘tied’ internally managed funds with a combined market value of £37.5bn. A tied internally managed fund is defined as a fund managed internally but by a commercial investment management operation. An example of this would be one of the large clearing bank pension funds which is managed by the fund management arm of the organisation. For the purposes of this investigation we focus on the 19 ‘pure’ internally managed funds (Table 1).
The internal investment management method is used by a relatively small number of funds but they do represent a large value of pension fund assets, albeit reducing over the last 10 years.
When a fund considers its management method the internally managed option is usually dismissed up front, if even considered at all! There are two main reasons for this outcome:
The investment consultants dominate the manager selection market and only have limited experience of internal mangers. On the other hand investment consultants work very closely with external managers and have extensive research database at their disposal. Investment consultants also have the commercial conflict where their income stream can be enhanced by the appointment of multiple external managers. Under these circumstances it is very unlikely that investment consultants would even contemplate proposing internal management as an option.
Internal management is only viewed as a viable option for very large funds. This is confirmed to a certain extent by the fact that of 19 internally managed funds at the end of December 1998, eighteen were valued at close to or over £1bn. Only one fund valued at £328m was substantially below the billion pound mark.
In reviewing the relative merits of internal and external management the three key factors to take into account are:
q Management expenses.
For the purposes of this analysis we have compared the performance of the internal manager’s universe (19 “pure” internal funds) to that of the external manager’s universe (WM all Funds Universe ex the internally managed funds). This analysis takes no account of the fund’s actual benchmark, the majority of the internally managed funds will not have the WM All Funds Universe as their benchmark. However most scheme –specific benchmarks sit comfortably within a peer group analysis and are generally indistinguishable from ‘Universe’ funds. The purpose of this report is to review how internal managers have fared compared against their external competition.
Another area requiring careful interpretation is the contribution to return from return from asset allocation. Internally managed funds are generally the largest and most mature UK pension funds and consequently could have a very different asset structure. However, this is not the case as the internal manager’s universe has a fairly similar asset structure to that of the external manager’s universe (see relative asset mix Chart 1). The major difference is the Internal Universe’s higher commitment to property (7% versus 4% at 31.12.98).
Note that although there were 19 internal funds in 1998 the past performance of the internal universe includes other internally managed funds that have since moved to external management. This avoids any claims that the results are influenced by a survivor bias.
Over the one,three and five year periods to end December 1998 9Table 2) the internal funds universe has outperformed the external manager’s universe. The level of outperformance has from 0.5% pa over the five year period to a full 1% in the latest year. Both asset allocation and investment selection have contributed to the superior result. Over the longer term period of 10 years the internal fund’s universe return was marginally below the external manager’s universe due to the detrimental impact from a higher commitment to property. On an ex- property basis the internal fund’s universe out performed the external managers universe by 0.5% pa over the 10 year period.
On a rolling 3 year basis (Table 3) the internal funds performance has been in line or above the external universe in four out of the five periods shown above. The underperformance in the first three year period was mainly due asset allocation and in particular the higher commitment to property. The returns available in property over this period were well below other markets.
A full performance review of the internal fund’s universe compared to the external manager’s universe is detailed below. The analysis is shown both on an inclusive and exclusive of property basis.
We have identified that the internal fund’s universe has produced superior returns compared to the external manager’s universe and the next stage is to analyse the risks taken to achieve this result.
Risk- the volatility of relative returns (measured by standard deviation) – is assessed over rolling 36 month periods and a summary of relative returns and relative risk is summarised below.
Over the last five rolling three year periods the internal fund’s relative returns have improved to the point where they are approaching upper quartile performance. Over the same periods the internal funds relative e risk has fallen from median to generally lower quartile.
Below we also show a detailed risk/ return attribution assessment. The scattergram on page 64 shows the internal funds generally well grouped with above average returns and a lower level of volatility.
WM research produced a survey of UK pension fund running costs in 1997. Responses were received from 73 funds with a combined market value of £104 bn. This represents around a quarter of the UK pension fund industry by asset value. The average fund size of the survey was £1.4 bn.
These funds were broken down in to the following management methods:
The average cost for the 73 funds was 13 basis points (bp). However, there are significant variations in the level of total costs, ranging from less than 4bp to more than 75bp. The chart below shows the average cost in basis point form for the investment management of securities and property for each management method together with their respective range:
On this survey it would appear that the investment management costs of internally managed funds are significantly lower than external management. Given that funds should be concerned with their ‘net of fees’ investment returns, internal management has a strong advantage due to their lower cost base.Reviewing the performance on a ‘net of fees’ basis would further enhance the internal fund’s relative performance figures.
Including property: Table 4
q The internal funds’ universe return of 14.8% was 1% above the external manager’s universe return.
q The superior performance was due both to asset allocation (more committed to UK bonds and holding a lower level of liquidity) and investment selection decisions (superior UK equity returns partly offset by underperformance in North America and emerging markets).
Over three years
q The internal funds’ universe out performed the external managers’ universe e by 0.7 % pa (internal 14.4 %pa, external 13.6 % pa).
q asset allocation (policy) added 0.3 % pa to relative performance. This was mainly due to a lower commitment to overseas bonds and cash.
q Investment selection added a further 0.4 % pa with above average returns in UK equities in the last two years the key factor.
Over five years
q The internal funds’ return of 11.5% pa was 0.6 above the external funds’ average return
q asset allocation and investment selection both added 0.3 % pa to relative performance.
q The internal funds benefited from being less committed to emerging markets, overseas bonds and cash and from above average returns in UK equities in three of the five year period.
Over ten years
q Over the longer term period of the internal funds’ return was 13.3%pa marginally below the external manager’s universe return of 13.4% pa.
q The reason for this slight underperformance was due to asset allocation (-0.3% pa) and in particular the above average commitment to property.
q Investment selection (+0.2% pa) proved favourable over the period with above average returns in UK equities in seven of the 10 years the key factor.
Excluding Property: Table 5
q The internal funds’ universe return of 14.9% was 1% above the external managers’ universe return.
asset allocation added 0.7% to relative performance with the internal funds’ above average commitment to UK bonds and a lower level of liquidity the key features.
q Investment selection added a further 0.3% to performance with superior returns in UK Equities being partly offset by below average returns in North America and emerging markets.
Over three years
q The internal funds return of 14.4 % pa was 0.7% above the external manager’s universe.
q Asset allocation and investment selection both contributed to relative performance.
q The internal funds benefited from being less committed to emerging markets, overseas bonds and cash from above average returns in UK equities in three of the five years.
Over ten years
q Over the ten year period the internal funds’ return of 14.2% pa was 0.5 % pa ahead of the external managers’ universe return of 13.7% pa.
q Asset allocation added 0.2% pa to relative performance. The internal fund’s benefited from holding less cash and overseas bonds.
q Investment selection increased the relative performance by a further 0.3% with above average returns in UK equities in seven of the 10 years the key factor.
In the latest three year period the internal universe average out performed the external universe by 0.7% per annum and was in the top third of relative returns (See summary return and risk chart, page 62). The internal universe has been in line or above the external universe in four out of the five rolling three year periods shown.
The internal universe’s relative risk has generally been in the lower quartile of total fund risk.
Asset allocation (policy)
The fluctuations in the contribution to return form asset allocation are generally influenced by the relative performance of property. However, the component of risk attributable to asset allocation has been below median and close to lower quartile in the period1994 to 1997.
An excellent result, generally positive contributions to return form selection form a lower level of risk.
The contribution to relative performance from selection has been positive in four of the five rolling three years
The risk component attributable to selection has been well in the lower quartile of relative risks except for the first three year period. In the first period the relative risk was very similar to the median risk.