Article
26 Mar 2020

Moving Asset Management In-House?

Securities Services
Institutional investors are increasingly taking control of their investments by managing them in-house. This has implications that extend beyond portfolio management and to manage assets in-house successfully, institutions need to build the supporting infrastructure.

Traditionally, institutional investors have outsourced asset management to external managers. However, scrutiny on fees combined with a low yield environment has led many institutional investors to bring asset management in-house. In 2018, according to bfinance, almost 20% of institutional investors had increased the proportion of assets managed internally in the last three years and another 10% planned to in the following year. The insourcing trend is more prevalent among larger institutions, where 45% of institutions with assets above $25 billion manage a higher proportion of their assets in-house compared to three years ago. Furthermore, the world’s five largest sovereign wealth funds manage more than half of their assets internally, almost $2 trillion.

Cost is usually the main driver for bringing asset management in-house and the savings can be significant. The California Public Employees’ Retirement System, the largest US pension fund, estimates that the transition to internal management and decreasing the number of outside consultants and advisors saved it $239 million in external management fees and operational expenses over the past seven years.

Beyond cost savings, insourcing gives institutional investors more control of their investments, which can help better align them with their funds’ philosophies and beneficiaries’ beliefs. This is especially relevant to institutional investors who prioritize environmental, social, and governance-based investing principles because they can directly engage with companies in which they invest, through proxy voting, shareholder filings, and on-site due diligence.

Largest Global Sovereign Wealth Funds: Proportion of Portfolio Managed Internally

 

Sovereign Wealth Fund

Fund Value (Billions USD)

Proportion of portfolio internally managed

Norway Government Pension Fund Global

1,073

96%

China Investment Corporation

941

37%

Abu Dhabi Investment Authority

697

45%

Kuwait Investment Authority

592

5%

Hong Kong Monetary Authority Investment Portfolio

509

66%

Source: Official annual reports for respective sovereign wealth funds, as of 2018 fiscal year-end

As institutional investors move investment management in-house, they should be mindful of the building blocks that are important to a successful transition. In addition to portfolio management, institutions need to invest in other areas such as governance, operations, and technology. Institutions should consider the costs associated with establishing these functions when conducting the cost-benefit analysis of insourcing investment management.

Five Considerations When Insourcing

Bringing investment management in-house is not an easy process. To ensure institutions realize the full benefits, they should consider the organizational, operational, and technology implications.

Define your Target Operating Model

An institution’s operating model is the foundation of a successful in-house investment management program. Institutions looking to internalize investment management can start with a clean canvas to develop a blueprint of their optimal operating model. This includes reviewing the technology, infrastructure, processes, and service providers required to support the investment program.

A key decision is whether to build or buy the technology for their operational systems. Without the burden of legacy systems, most institutions will likely look to leverage third-party technology. Advances in technology have created cloud-based solutions, modular and interoperable systems that can lead to cost savings, along with transparency for risk management, oversight, and control. Another important decision is to determine which activities should be outsourced. Institutions can leverage the expertise of service providers for the non-core, yet critical functions, such as custody, fund administration, performance measurement, and compliance monitoring. Pushing further into the front office, institutions can also consider outsourcing the investment book of records process and, in some cases, trading activity. This can result in cost savings and allow institutions to focus on managing investments.

Set your Data Strategy

An institution-wide effort around data governance and management will help institutions manage their assets effectively. Institutions often have multiple systems that generate and store large quantities of data but these systems may not be interoperable. This can create data segregation and prevent institutions from getting a holistic view of their data. Institutions can combat this issue by harmonizing data sources and consolidating them into a centralized repository to ensure that teams use the same data. They should ensure that data systems are built with capabilities to feed in all trading positions along with related internal and external data sets.

Regulatory reporting has also become a prevalent component of data strategy in recent years. Depending on the scope of their operations, institutions are likely to face reporting requirements from regulators across jurisdictions. Often these requirements draw on the same underlying data but require different formats. Institutions can use their data strategy to approach regulatory reporting holistically to create an efficient, cost-effective solution.

Invest in Talent

One of the most critical considerations is appointing portfolio managers and research analysts with the appropriate expertise. Typically, institutions start by insourcing more traditional assets, such as cash and treasury bonds and passive strategies, which are cheaper to manage and may not require specialist knowledge. As institutional investors start to manage more complex assets, such as infrastructure and private equity, specialist expertise is needed.

Investing in operations, technology, and functional roles to support in-house investment management is also important. Post-trade specialists can perform operational functions including corporate actions, performance measurement, and calculating the fund’s net asset value. Data specialists, software developers, and enterprise security teams can implement the supporting technology architecture, while risk professionals can develop and oversee the risk management and governance frameworks.

Many institutional investors, especially in the public sector, have tight budgets that can limit the remuneration of investment professionals. They are competing against the private sector, where many asset management institutions have more flexibility to offer higher compensation. Public sector institutional investors can combat this by highlighting non-financial benefits, such as the fund’s vision and purpose, work-life balance, opportunities for professional development, and job security.

Establish your Governance

Institutions should be able to leverage their existing investment committee structure to oversee the in-house investment management. However, they should be mindful of potential conflicts of interests that could arise from having the investment management in house. Additionally, institutions need to consider governance issues beyond the investment process. This includes frameworks for the oversight of third-party service providers and any outsourced functions. Along with the outsourcing contract, which details the business functions being performed by the service provider, service-level agreements should be put in place to create Key Performance Indicators (KPIs) and aide in tracking the service provider’s performance. These KPIs should be reported frequently and used in service reviews, where the institutions and service providers have the opportunity to clarify any issues.

Develop your Risk and Control Framework

When bringing investment management in-house, operational risk transfers from external parties to the institutional investor. This means that institutions need to develop risk and control frameworks to oversee the end-to-end investment process. Generally, there are three components of a risk and control framework.

The first is the operation level, which focuses on developing the risk and control requirements for each operational function. This includes ensuring staff is adhering to the guidelines and identifying areas of potential risk. The second element is the risk and control function, which is led by the Chief Risk Officer (CRO). The CRO is responsible for the day-to-day risk management activities including creating and monitoring risk measures via standardized reporting. Additionally, they typically lead the relationship with regulators. The final element is internal audit, which performs an internal assessment of the control environment and report to the institutions board. For many institutions that may have historically focused only on investment risk, this expanded risk management framework will be new.

Building a Foundation for Success

Institutional investors are likely to explore insourcing investment management as a way to combat continued market pressure. The investment management process is a small component of an insource strategy and it is important that institutions take a holistic approach in their planning. Focusing on the technological and operational elements of the investment management process can help institutions ensure they have the right foundation in place to build a successful insource solution that can help lower costs and deliver returns for their stakeholders.

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