BRINGING ASSETS IN-HOUSE Considerations for success An interview with Shankar Subramanian Principal - Public Funds Practice Cutter Associates, LLC Under pressure to reduce spending on external investment managers, many public pension plans have decided to bring management for some asset classes in-house. Funds that do end up insourcing management of some assets end up not only reducing their spending on external managers, but also enhancing their capabilities to monitor, evaluate, and report on risk and performance. In addition, they can exercise greater control over their assets. But decisions about insourcing and outsourcing are complex, and Funds need to carefully analyze a number of criteria, including the operational costs, to know whether the move would be wise for their firm. We sat down with Shankar Subramanian, Head of Cutter Associates Public Funds practice, to get his expertise on the subject, including what options Funds have from a technology and operational standpoint. What are the primary factors driving public pensions to bring assets in-house to manage internally? Pension Funds, especially in the US public sector, are dealing with a number of challenges today. Funds are facing a growing retiree base and a prolonged low interest rate environment that has led to systemic underfunding, as well as increased regulatory scrutiny and growing demands around transparency and reporting. These issues are added to the traditional challenges of attracting and retaining investment management talent, legislative constraints, and limited budgets. Yet, amongst these obstacles, Funds are still mandated and are committed to meeting their pension obligations and achieving the performance targets needed to ensure their success and viability. Funds have long subscribed to the time-tested theory of investment diversification and traditionally sought the expertise of third-party consultants to develop asset allocation models. Funds would then seek to execute on the prescribed investment mix through the awarding of mandates to external third-party managers perceived to have expertise in a particular strategy.
The Funds expected the external managers to provide investment exposure and performance that would more than make up for their fees. Unfortunately, many of these strategies did not perform as expected and did not materially outperform the indices they were being measured against. Over the past decade and specifically within the past five years there has been a proliferation in new, low cost investment vehicles, such as ETFs, that have provided Funds the ability to easily gain exposure to an asset mix or strategy without having to pay the higher fees typically associated with third-party external mandates. These products have given Funds greater flexibility and control over their portfolios and have allowed them to react more quickly to market events. By bringing the investment management capability in-house, Funds have also enhanced their ability to evaluate, monitor, and report on areas of exposure and risk, as well as, performance data. 46% of asset owners that manage assets internally increased their in-house allocations in the last 2 years. Source: Rightsourcing - Finding the Best Business Model for your Asset Management and Related Operations, BNY Mellon, 2016 Also driving the trend toward insourcing are advancements in vendor technology and service offerings. Pension Funds have always struggled with traditional technology challenges, such as integration issues of best-of-breed infrastructures. But recently, Funds are using vendors offering cloud technologies and services that are less expensive to support, more readily scalable, and continually enhanced. The new offerings free up considerable time, effort, and resources the Funds previously dedicated to technology, which can now be directed toward strategic initiatives instead. Having made the decision to take assets in-house, what are the key factors from an operational standpoint that Public Funds need to analyze to ensure success? I believe four factors are really key - People, Organization, Technology, and Oversight. PEOPLE When it comes to people it can be a challenge for some Funds to find the expertise locally. Typically, investment management has been a well-compensated profession with the core of expertise in traditional financial hubs. It may be harder to attract the talent if you are under mandated pay scales and limits for compensation. It s also harder to hire if you must go through a rigorous process to gain approval from a board for any additional staff. Your recruitment personnel may need to get creative in attracting resources, such as targeting people who have ties to the area, emphasizing the local amenities, lower cost of living, or other quality of life factors. The good news is, having found personnel, staff turnover tends to be lower. ORGANIZATION The number, size, and complexity of the assets you re bringing in-house largely determine the functions required to manage those assets. Once you understand the functions you ll need, you have to decide whether to support each one in-house or through outsourcing. Today so many functions can be outsourced to third parties, and outsourcers usually provide expertise and scalability that Funds can t match in-house. But it s really important to understand the potential downside to outsourcing. Funds that outsource key functions are often surprised by how much work it is to effectively monitor service levels, and by how much oversight the vendor relationships requires. For each provider, you need to develop and maintain robust continuity, disaster recovery, and contingency plans in the event of a major failure, as well as an exit strategy in case you decide to bring the function in-house or switch providers. 2
OVERSIGHT When you ve decided which functions you ll support in-house, you need to set up your internal organization to manage them efficiently, from the front office to the back office. For the front office you ll need to develop and maintain controls and policies for risk and compliance, investments, reporting, corporate governance, trading activities, and asset allocation. Each of these functions requires complete, accurate, and timely data, so you ll also need a sound data infrastructure to support them, including data governance. And you ll need to support other functions too, related to settlement, valuations, corporate actions, cash management, and performance measurement and attribution. TECHNOLOGY And then of course you need technology that efficiently supports the people and functions that contribute to managing your assets in-house. Your existing systems might not be up to the task. Many solutions are available on the market but you need to understand how they align with your unique functional requirements, timeframes, budgets, and existing systems. That s a lot of activity to coordinate. How do Funds prioritize? Priorities can vary widely, because they should match your Fund s unique characteristics and strategies. We ve worked with several Funds that brought their low-risk assets in-house first their fixed income or passive strategy assets. That makes sense for some Funds but not for others. Management fees on passive strategy assets are low, so if you re counting on initial savings in management fees to finance staffing and infrastructure enhancements for the next phase of the plan, you might come up short. In that case you might be better off starting with assets commanding higher fees that would generate greater savings. For example you could bring Private Equity assets in-house first, moving from a fund-of-fund limited partnership to direct investments or co-investments. Of course moving Private Equity assets in-house is more challenging than moving less-complex assets in-house, so you need to determine whether you re prepared to meet those challenges. If you re not, you need to rethink your strategies and priorities. No matter what your situation, you ll find it easier to prioritize tasks if you lay out a long-range plan first. Then you can flesh it out with roadmaps that define the incremental steps, and priorities tend to fall into place more easily. A long-term vision also helps with the business case for getting budgetary and legislative approvals for investments in staffing and infrastructure. For every additional front office FTE, an additional 1.7 FTEs are needed in governance, operations, and support. Source: How Large Pension Funds Organize Themselves, Rotman International Journal of Pension Management, Spring 2012 We support a networking group at Cutter made up of our Public Funds. They find that talking with peers and learning from their experiences provides invaluable input into complex decision processes like these. In your role at Cutter Associates how do you help Public Funds to evaluate the risks and benefits of in-sourcing? Well usually we re brought in at a very early stage to help plan sponsors think strategically about their investment management capabilities and goals. Initial discussions often lead to them asking us to thoroughly evaluate their current operational capabilities and processes, identifying gaps and analyzing risks. We re fortunate because we ve been helping Funds build strategies for investment management technology and operations for a long time, so we can formulate recommended approaches by drawing on deep domain expertise and extensive knowledge of leading industry practices. When Funds decide to proceed with in-sourcing, they ve asked us to lead all aspects of an engagement including strategy and roadmap development, vendor selection, execution, implementation, training, and support. 3
One thing we ve discovered is that sometimes a Fund s early internal discussions focus on insourcing the portfolio management function without thinking through the operational and technology implications. These kinds of planning oversights can breed frustration for portfolio managers who end up having to resolve data management and operational issues, leaving little time for making investment decisions, which is their primary function. The good news about technology and operations is that there are many viable solutions available, including locally installed systems and outsourced solutions. Outsourcing investment operations is a particularly attractive option for Public Funds with limited resources, although cost isn t usually the primary driver. In fact, we ve found that achieving scale faster than they could in-house is the major driver. Which just goes to show that decisions about insourcing and oursourcing functions are multi-faceted and need to be made after careful consideration and consultation. SHANKAR SUBRAMANIAN Shankar Subramanian has 25 years of industry experience in investment management and technology solutions. At Cutter Associates, Shankar heads the Public Funds practice, providing thought leadership to the consulting practice and strategic and tactical advice to Cutter s many Public Fund clients. He is a regular featured speaker at Cutter Associates member events. Shankar has significant experience with pensions, buy side asset management firms, insurance firms, and government agencies. He brings a deep understanding of data management, equity portfolio management, risk management and alternative investments. Shankar earned his B.S. from the Indian Institute of Technology and his M.B.A. from the Indian Institute of Management. Want to better understand your options for in-house management? To find out more about Cutter Associates Public Funds expertise and information about membership in our Public Funds consortia, call us today on +1 339 469 0600 or +44 (0) 20 3440 4255 or email connect@cutterassociates.com. 4