The decision by Harvard to terminate half of its investment staff and outsource funds management bucks the global trend to internalise funds management. The underperformance achieved in the last decade came despite Harvard having all the factors necessary to recruit and retain excellent fund managers. Harvard has a great brand name, patient and substantial capital to invest, and a willingness to recruit and pay for the best talent yet internalisation failed. Given this, is internal management the sure thing many make it out to be?
Why Internal Management is So Popular
The primary reason internalisation has taken off is that many fund managers are awful. They fail to outperform after fees, they communicate poorly and they fail to offer clients a product that suits their needs. Given how poorly institutional investors have been treated it is no surprise that internalisation, index funds and ETFs have all grown substantially. All of these take market share and fees away from active managers.
Yet the blame for this cuts both ways; many fund managers are awful because they have been allowed to get away with it. Many institutional investors and their asset consultants have opposed a more competitive industry and failed to redeploy capital to managers who would do a better job. By failing to advertise mandates and locking out emerging managers who would deliver better outcomes capital allocators have unconsciously chosen to be treated badly.
In theory, internalisation holds out the promise of fixing all of these problems. By employing fund managers directly fees can be lower and institutional investors can have more control and flexibility over their capital. If great fund managers are hired, alpha will be generated. Top notch fund managers will be attracted to working for an internal team as they will no longer need to spend time on the laborious task of fundraising. The logic is so simple, yet Harvard has shown that it is far easier said than done.
Where Harvard Went Wrong
Harvard, like many capital allocators considering internalising funds management, forgot several of the brutal realities that the industry has proven out over time. These include:
- In most asset classes generating alpha after fees is very difficult. A few exceptions in Australia are small capitalisation shares and credit, which both have substantial information gaps that hard working funds managers use to create sustainable, long term alpha. In highly competitive, information rich sectors such as large capitalisation shares, private equity and hedge funds, managers as a group are taking the majority and in some cases more than all of alpha generated.
- There are a small number of truly great fund managers and these people generally get to set the terms on which they work. They are often closed to new capital and in some cases are returning capital.
- Getting great talent to manage your money, whether internally or externally, requires a similar set of skills to that of a great fund manager. You have to work hard to find the best opportunities, monitor existing positions and free yourself from as many distractions as possible to become and remain successful.
There’s often a naivety amongst capital allocators that these brutal realities won’t apply if they internalise funds management. Capital allocators ignore the roadblocks they create that stop them from building successful internal funds management teams such as:
- Setting up internal teams targeting areas that have little or no net alpha. Why go to the effort and expense of targeting large capitalisation shares, private equity and hedge funds which can easily and very cheaply be replaced by an index fund or ETF?
- Being unwilling to pay sufficient incentives to attract and retain the best talent. If an internal fund manager is substantially beating an index there is good reason to pay them 5-10% of the outperformance. If they are paid many times more than the CEO that reflects their greater contribution to member’s financial outcomes.
- Taking away discretion on investment decisions and loading up fund managers with administration and office politics. These will detract from their investment performance and job satisfaction, making an internal environment a less appealing place to work than a boutique funds manager.
Don’t Forget the Cultural Differences
Proponents of internalisation often forget that fund managers can have a very different work culture. Fund managers that think and act the same as others are almost guaranteed to underperform. Some fund managers are eccentric or egotistical, and are likely to clash with a more bureaucratic culture particularly compliance, HR and investment committee staff. Requests for perfunctory reporting and attendance at general meetings may be ignored. These sorts of actions can have a debilitating impact on staff morale in a collegiate culture. It’s also forgotten that when things go badly wrong, it is much easier to terminate a fund manager than an employee.
Internal and External Aren’t the Only Choices
It’s tempting to see internal and external funds management as the only two choices available, but they are simply two different ends of a spectrum. In between these two positions is a range of options that can lead to far better outcomes for all involved. Some capital allocators have set up external teams, which share compliance, legal and HR functions but that have separate offices and a clear mandate to work to. Others have seeded new managers, or bought part or full stakes in existing managers. Some capital allocators are giving their fund managers broad mandates, allowing them to be opportunistic in allocating capital within or across several asset classes as value presents.
Another strategy is to substantially reduce the number of managers used, with low alpha sectors indexed leaving more time for deep relationships with managers that can generate meaningful alpha. These deeper relationships benefit both parties with capital allocators getting higher returns, lower fees and a rich source of insights that informs their investment decisions in other sectors. Fund managers are able to take advantage of the best opportunities for their clients. Trust is built such that fund managers can make the call that there isn’t value in one area and know that they will be given the opportunity to redeploy capital to another area with better value.
Sometimes You Just Have to Ask to Get What You Want
For many capital allocators, the pathway to getting better outcomes isn’t to internalise but to change the managers they have. It is common business practice to run a competitive tender for the provision of services, yet capital allocators rarely do this. They allocate capital without advertising what they are looking for largely eliminating the competitive tension that a public tender would create. Even worse, many capital allocators and asset consultants refuse to take meetings with managers that have higher returns and lower fees than their current managers.
This raises the issue of whether the underperformance problem is mostly due to capital allocators rather than fund managers. Before investment committees sign-off on internalising funds management they should be asking whether the existing staff are doing a good job at picking managers. If the existing staff don’t know to discover, select and negotiate with high performing fund managers what chance does a capital allocator have of finding and selecting these same people to work for them internally?
Internalising funds management is a growing trend, mostly in response to the poor performance of many fund managers. However, internalising funds management isn’t an easy fix with remuneration and cultural differences commonly creating issues. Alternatives to internalisation can include index funds, starting or seeding new managers, and buying equity in existing managers.
Before signing off on internalising funds management, capital allocators should consider whether their existing staff are willing and able to select great fund managers. If their track record isn’t strong, they are unlikely to be able to recruit high performing fund managers to work internally. Rather than internalising funds management, the solution might instead be changing the capital allocation process and staff.
Written by Jonathan Rochford for Narrow Road Capital on February 20, 2017. Comments and criticisms are welcomed and can be sent to email@example.com
Narrow Road Capital is a credit manager with a track record of higher returns and lowers fees on Australian credit investments. Clients include institutions, not for profits and family offices.