Rock-solid support from pension fund boards of trustees, investment committees or whatever entity holds fiduciary responsibility is absolutely essential for internal investment management.
“Governance is critical,” said Charles Thomas “Tom” Tull, chief investment officer of the $25 billion Employees Retirement System of Texas, Austin.
Pension fund chief investment officers interviewed strongly agreed with Mr. Tull's statement, as did external governance experts.
“We have a close and collaborative relationship with the board,” said Jeb Burns, chief investment officer, Municipal Employees' Retirement System of Michigan, Lansing, which has about 20% of its $9 billion of plan assets managed internally.
Mr. Burns noted that investment officers have worked with MERS' board to make sure that both parties fully understand and accept the pension fund's investment policy statement and the investment discretion that staff have over its implementation. Trustees receive performance metrics for both internally and externally managed assets.
“Culture matters and we have it. There's a mission focus here,” for both investment officers and the board, Mr. Burns stressed.
Culture aside, Funston Advisory Services LLC, Bloomfield, Mich., a governance specialist consultant, dentified four key factors for consideration by fund boards contemplating a move to internal money management, said Rick Funston, managing partner:
nsize of the asset pool, which has historically been between $20 billion to $25 billion;
nsufficient budgetary control to allow approval for hiring more staff or infrastructure upgrades;
nwillingness and ability to pay internal investment officers market-competitive compensation; and
nconfidence from the board and staff that net returns in an asset class can be improved through internal management.
“Boards wrestle with a number of issues,” Mr. Funston said, particularly whether trustees have budgetary autonomy for staffing and systems. “If it takes legislative action to get funding or authority to make changes, it can be expensive in terms of time and smooth operations,” he added.
Beyond the governance-level feasibility questions lie issues with which every asset manager has to deal.
Internal investment management is “easier said than done. This is not for the faint of heart. There will be "come to Jesus' moments,” said Virgilio “Bo” Abesamis III, executive vice president, trust, custody and securities lending group, Callan Associates Inc., San Francisco.
The right investment department structure is as equally essential to successful internal management as governance, and Mr. Abesamis said it must include all of the following factors: access to data; skilled, talented investment officers; adequate systems infrastructure; and administration, including compliance and risk management.
“CIOs have to weigh the decision point: Passive managers can provide investment management at very competitive costs that can be hard to beat,” Mr. Abesamis said. He added that there are “a lot of very complex factors involved in managing passive strategies such as whether to use full indexing or sampling as well as dealing with frequent index reconstitution.”
CIOs must have “command of every detail of internal management,” from attracting the right portfolio managers, research analysts, traders and compliance staff to building or buying robust investment, trading and reporting systems or handing it over to an outsourcer, Mr. Abesamis stressed. Details such as much closer oversight of proxy voting, managing securities lending programs in-house and tighter control over liquidity can be advantages for the pension fund but require CIOs to be “masters of their domain,” Mr. Abesamis added.
Some pension funds — which Mr. Abesamis declined to name — have adopted a “training wheels” approach to internal management by hiring a passive manager as a subadviser to the internally managed portfolio, he said. The arrangement allows pension funds to run the strategy on the money manager's investment infrastructure and to benefit from knowledge sharing of professional portfolio managers.
The advantage of “this experiment is that it is the best way to train pension fund investors to become true money managers and traders,” Mr. Abesamis said, noting that having a subadviser as a mentor “softens the blow if it isn't successful.”
Whichever way pension CIOs decide to structure internal management programs, Mr. Funston said “the real key is demonstrating a clear business case to the board of trustees,” covering everything from costs, savings, staffing and how internal investment teams will achieve good risk-adjusted returns. n
