It's not all one-way traffic

Key to the issue of outsourcing is whether to manage assets in-house or to appoint a third party investment manager. According to George Urquhart of the WM Company, internal managers are finding themselves under pressure from tight human resource budgets while trustees and plan sponsors are under pressure from consultants and from outside managers with considerable marketing budgets.
Internal management has many attributes though. Managers are under a lot less pressure, typically they have a better relationship with trustees and they are able to take a longer term view – trade volume and turnover tends to be much lower using internal management. It is also far cheaper. WM recently carried out research for an internally managed pension scheme where costs were as low as two basis points. Mandates covered externally cost over 40 basis points, although in mitigation this was for specialist management. While this is not comparing like with like, Urquhart says that in-house management works out cheaper across the board, even for passive strategies.
WM Company’s 1999 report ‘An Analysis of Internal Investment Management’, found that internal outperformed external managers while registering lower relative risk. Urquhart, who is updating the report (due for publication next month) doubts whether, on a risk adjusted basis, internal managers will fare any worse than their external counterparts. “In the past they have produced some very good results,” he says.
Roy Peters, CEO of Aerion Fund Management in London, is responsible for the E21bn Lattice Group pension fund, where they manage 90% of the assets in-house while using external managers for emerging market, private equity and property mandates. According to Peters, another advantage of internal managers is that they are able to focus on one client rather than on numerous portfolios for a variety of clients. Internal managers are free from the burdens of developing new products and trying to build up international business.
Despite this, there is ample evidence to suggest that pension funds are pushing out more of their assets. Greenwich Associates’ last report asked pension funds to predict their positions in 2002. In 1998, 73% of European pension fund assets were managed by the schemes themselves but as of 2002, Greenwich says this figure looks like falling to 67%.
There are numerous explanations for the trend to outsource. First is the belief that investment today is more complicated – pension funds are using ever more exotic classes and to do so requires external managers. Here there is an element of truth and it is rare to find internal teams looking after private equity, property and emerging market briefs for example.
Trustees and plan sponsors are under pressure to take a more ‘professional’ approach and, for that, appoint external managers. Whether this is actually a correct interpretation is open to debate and many in-house teams need only cast a glance at the performance of the so-called ‘big four’ external managers in the UK to back their arguments.
It’s far from one way traffic though, with some of Europe’s larger schemes bringing more of their assets back into the fold. PGGM, the Netherlands’ second biggest fund has the rather unusual policy of splitting most of its mandates between in-house and external managers, typically but not exclusively 50:50. Investment strategist Niels Kortleve says the approach keeps them in touch with the markets. “By having internal portfolios next to the external portfolios you have more inside knowledge of what is happening in the market and you are therefore better able to judge the added value of the external managers.”
In 1995, the fund increased its equity share but appointed external managers to do so. “Over time we gained more experience and we came to the conclusion that we are able to start up a portfolio in the local equity markets,” says Kortleve. So, in 1998 the fund began managing a Dutch equities mandate and extended it to cover European equities a year later. Last year it started a Japanese equity portfolio in-house while they are working on bringing some of the existing US portfolio in-house. “We didn’t have the experience when we decided to increase the equity exposure. We now think we have the expertise,” he says.
Comparing performance between in-house and external equity managers is tricky since PGGM has only been doing it for three years. But, for fixed income, the in-house managers have outperformed their external counterparts. Despite superior performance, a lack of expertise prevents them from managing all the fixed income and for some markets it is either simply too difficult or expensive to manage portfolios internally. PGGM uses external managers for its emerging markets equities and although it is adding corporates and high yields to its fixed income portfolios next year, it lacks the expertise to oversee these themselves.
Managing funds in-house requires considerable size to produce worthwhile economies of scale; a theory confirmed by the Greenwich figures, which show propensity to outsource, is inversely proportional to fund size. For funds in continental Europe with more than E2.5bn, 80% of total assets are managed in-house while at the other end of the scale, only 13% of total assets belonging to funds with less than E125m are managed in-house.
Those funds with the resources to manage internally enjoy the added bonus of it being a lot cheaper. Internal managers do not have the marketing expenses that external managers have, in some circumstances up to 30% of total costs. Expenditure on total salaries and office space is less and, most significantly, managers are not under pressure to turn a profit. When you reach the size of many of the UK funds and PGGM, cumulative savings can be significant.

In the UK, home to some of the largest funds in Europe, there remains a core of schemes that manage most of their assets in-house. Among those that do so are British Airways, British Aerospace, BP Amoco, Shell Pensions, the Lattice Group and many of the local authority funds. But as consultants continue to recommend external managers and larger external investment managers continue to market heavily, so the in-house manager faces more of a struggle.
Continental European pension schemes appear more willing to appoint outside managers. In July, the E3bn Lisbon-based Portuguese pension reserve fund announced that it would make over as much as 20% of its overall assets to external managers by the end of the year – to date the fund has run the assets itself. Switzerland’s new E6.5bn pension foundation for the post office appointed Jurg Puchar as president of the board in May and announced that it is creating a company to run the fund’s assets as of next January.
Peters at the Lattice Group admits there are problems with running the portfolio in-house, foremost being the retention of bright and ambitious staff. External managers are able to pay better salaries and offer more in terms of career development and foreign postings. Internal managers are in addition more reliant on external research than external managers who likely have their own research departments. That internal managers face the muscle of third parties is a shame, as Graham Wood of WM Company says, “Internally managed funds are very efficient”.