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December 17, 2019 10:00 AM

Commentary: When the path to alpha leads home

Dan Houlihan
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    Dan Houlihan
    Dan Houlihan

    The prospect of reduced fees and increased control are drawing more institutional asset owners to consider building their own in-house investment teams, moving away from the long-standing model of hiring external managers. Insourcing investment management is a global trend for asset owners with the potential to generate alpha through lower fees and potentially better investment returns. But without the right operating model, those rewards might be elusive.

    While news reports and research show that fee savings are real for asset owners that choose to manage assets in-house, the cost side of the ledger is more complicated. Asset owners face some tough questions: Can they handle the governance challenges that increased operational risk brings? How will they manage the added costs of running an internal operation? Do they have the right technology in place to optimize decision-making? These are all important considerations in the move to an internally managed investment model.

    Mapping out good governance

    The in-house investor's operational model starts with good governance. A recent study by Ernst & Young found that nearly a third of pension and retirement providers think their investment governance frameworks are lagging behind the increased pools they manage, and this doesn't take into account the added risk that an internal investment team assumes.

    It is essential to set clear roles and responsibilities, with appropriate separation of duties and tools in place for timely decision-making and effective control. Performance benchmarks are key to determining whether the in-house investment team is doing a better job than an external manager. One measure of governance is whether an asset owner would "fire" itself as manager if it didn't think it was delivering investment value.

    For our own research, we interviewed a number of asset owners who also pointed to governance as a key to successful insourcing. One head of operations at a multibillion-dollar pension plan commented to us that having the right governance structure for every step is crucial. For trading strategies, the operations chief said executives at the pension plan rely on certain investment committees that approve all new strategies and products. They ensure they have the right support structures in place to have appropriate segregation of duties.

    Managing costs

    Cost is a major factor in determining whether it makes sense to bring investment management in-house. These include staffing, compliance and technology costs inherent in an effective investment operation.

    The cost of finding and retaining talented staff can be significant. Asset owners need to ensure that their compensation structure is equitable and attractive for their staff in an increasingly competitive market. An internal asset management operation goes beyond investment professionals or traders to include the range of front- and middle-office teams and everyone involved in the logistics of portfolio management that need to be included in staffing considerations.

    Compliance costs vary and encompass the need to ensure that operational compliance and regulatory requirements are met. There are costs associated with having skilled and knowledgeable compliance staff as well as the tools necessary for them to adequately perform their roles. For example, new regulatory technologies in the reporting space can provide automated platforms, visual analytics and business process management tools, but these all come at a price.

    Managing and upgrading technology is costly both from a financial and resource perspective. An asset owner with an in-house management operation needs pre- and post-trade compliance tools, order management and execution management systems, as well as a functioning investment book of record to facilitate accurate decision-making by the portfolio management teams.

    Upgrading technology infrastructure

    Today, an effective investment management operating model has technology at its core. Successful companies leverage technology that allows them to redesign long-standing processes. For example, machine learning can perform repetitive tasks faster and with greater accuracy. Public and private cloud capabilities provide efficiencies and scale to power businesses. Predictive analytics are crucial tools that deliver data-driven insights to support decision-making.

    As asset owners consider insourcing their investment operations, they might want to evaluate whether it makes sense to buy or build new technology, or to outsource certain functions to a third-party provider that already has the technology built into their solutions.

    Choosing the right path

    In deciding to bring asset management in-house, asset owners must always think about what value they are gaining. For many, this leads to a focus on their core investment proposition, and perhaps outsourcing ancillary components of the value chain. These can include functions such as collateral management and foreign exchange, back- and middle-office operations (portfolio accounting and analytics, compliance, client reporting), as well as trading activity.

    Governance and operating model are key considerations for insourcing investment management — and may be underestimated by asset owners. The goal for an in-house investment management team should be an operating model that allows them to focus more time and resource on functions where they truly add value, namely driving increased returns. Every institution is unique, and those that want to future-proof their operations are re-evaluating their operating models to take advantage of new opportunities, methodologies and innovation.

    Dan Houlihan is president of asset servicing, Americas at Northern Trust Corp., based in Chicago. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.

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