'Insourcing' trend growing among big institutional investors

Large institutional investors increasingly are “insourcing” asset management to improve returns by cutting costs.

That's the opposite of the trend toward smaller institutions outsourcing some or all of their investment operations.

Among the large institutional investors shifting more assets to internal management, known as insourcing, are the $258.3 billion California Public Employees' Retirement System, Sacramento; the $27.3 billion South Carolina Retirement Systems, Columbia; and the $78.1 billion North Carolina Retirement Systems, Raleigh.

The $26.6 billion Texas Permanent School Fund, Austin, is easing out of funds of funds and into a hybrid model that pairs staffers with external managers that together run direct investments in private equity and hedge funds. Eventually, the portfolios will be 100% internally managed.

Internal management isn't new: 26% of the 200 largest U.S. defined benefit plans reported that staff managed some portion of the fund as of Sept. 30, according to Pensions & Investments' annual survey . Aggregate internally managed assets totaled $932 billion, 22% of the $4.2 trillion reported by the biggest plans.

The cost savings of switching to insourcing are significant, according to analysis of Dec. 31, 2010, data by CEM Benchmarking Inc., Toronto:

• The median cost for internally managed active equity strategies was 10 basis points, vs. 40 basis points for externally managed strategies.


• For fixed-income strategies, the median internal cost was three basis points compared with 18 basis points for external.


• For real estate, the median internal cost was 21 basis points vs. 75 basis points for external and 134 basis points for an external fund of funds.


• In private equity, the median internal cost was 25 basis points vs. 165 basis points for external and 244 basis points for external funds of funds.

CEM found pension funds with more money managed internally had better returns. For every 10% increase in internally managed assets, the additional return was a net 3.6 basis points.

“Nothing is going to reverse this trend” toward insourcing, said Michael C. Schlachter, Denver-based managing director at Wilshire Associates Inc.

“Every six months or so, you will see another large pension fund adding another asset class portfolio to its in-house management program,” Mr. Schlachter said. “The drivers are the excellent economics of internal management, the sexiness of managing billions of dollars, and the enhanced responsibility of good stewardship of your plan's assets.”

Another investment consultant, who asked not to be named, said the “real driver is less along the lines of cost savings, but more a lack of trust with some segments of the industry. ... (For example) custodians trading currency as principal really burned some public plans, and some are just going to take that sort of activity in-house.”

Chief investment officers stress that the real goal is cost savings that lead to better investment returns. “There is really strong evidence ... that funds that can manage assets internally have an advantage,” Joseph Dear, CalPERS CIO, said during a presentation in late April at the Milken Institute Global Conference in Beverly Hills, Calif.

CalPERS internally manages 80% of its public equities and 92% of its fixed-income portfolio. “We're paying a fraction of a basis point for it. It's incredibly efficient,” Mr. Dear said.

“Somebody's going to get paid to manage the investments. If it's not a public employee doing it, then it's going to be the private sector and they're going to get 10 times at least” what it would cost to manage the funds internally, he said.

“I don't mean that this is the automatic reason to do or not do insourcing,” Mr. Dear said, adding that excellent economics are a “powerful reason for large institutional investors, pension funds, to develop that capacity.”

Plans are afoot to insource about $500 million of CalPERS' $3.6 billion international fixed-income portfolio (P&I, April 30). Increasing the international equity portion also is under consideration (P&I, April 1).

The South Carolina Retirement System Investment Commission, which manages the state pension plan, is seeking a legislative appropriation to move management of the fund's domestic equity portfolio in-house, CIO Hershel Harper Jr. said in an interview. The current target allocation to U.S. small- and large-cap equities is 14% of plan assets.

Investment commission staffers now manage the system's short-duration securities and cash allocations internally. Those asset classes have target allocations of 3% and 2%, respectively.

But the domestic equity program will be the first large-scale move to in-house management for the plan, Mr. Harper said. The plan is to start managing U.S. equity in enhanced index strategies and once “proof of concept” is successfully established, to move to active management, he said. Over time, international equity — now with a 16% target allocation — likely will be brought in, too, he said.

Because the investment commission won't entirely abandon external equity management, Mr. Harper said two separate teams will handle internal and external management. The internal U.S. equity management program will start in fiscal year 2014, which begins July 1, if the Legislature grants the commission's request.

Given predictions of a decade of poor performance to come, the North Carolina Retirement Systems needs to shift more assets from equities and fixed income to reach its 7.25% long-term assumed rate of return, Janet Cowell, state treasurer, said. A bill to double the system's allocation to alternative investments to 40% is now moving through the state Legislature.

The pension fund pays $18 million annually in fees for alternative investment funds of funds, which could be reduced by moving to internal management. Ms. Cowell, sole trustee of the fund, said she doesn't have enough staff now to move more assets in-house. About 35% of the retirement system was managed internally as of Sept. 30.

The Texas Permanent School Fund obtained legislative authority to more than double its investment and support staff to 58 from 27, Debbie Ratcliffe, a spokeswoman, said in an e-mail. The fund's investment teams managed 56.8% of assets internally in passive equity, active fixed income and Treasury inflation-protected securities as of Feb. 28.

The Texas Legislature granted the staff expansion because “it is more efficient and significantly more cost effective to manage with internal resources than to pay external managers high fees or incur a double layer of fees in certain asset classes,” Ms. Ratcliffe wrote.

She said the new employees, 12 of whom have been hired so far, will manage or support investment alternative asset classes such as private equity, real estate and hedge funds, among other strategies.

The cost of the internally managed private equity portfolio will be 50% to 60% less than that of the fund's $1.3 billion externally managed fund of funds, John Grubenman, director of private markets, said during a webcast of the fund's April 17 finance committee meeting.

But insourcing is really only appropriate for large funds, said Wilshire's Mr. Schlachter.

“It's all a question of scale. A $500 million city pension system just won't be able to add enough talented staff. The plan has to be prepared to pay competitive salaries. You'd hate to be pennywise and pound foolish when it comes to building internal teams.”

The issue of attracting and retaining public pension fund investment staff is a thorny one, sources agreed.

“Public pension fund internal staffs are generally quite poorly paid. There is high turnover and that's costly when it comes to maintaining continuity in an internally managed strategy,” said Rodger Smith, managing director at Greenwich Associates Inc., Stamford, Conn.

“Let's put it this way. In the U.S., only one public plan CIO made more than $1 million in 2012. That was Britt Harris (T. Britton Harris IV), CIO of Teacher Retirement System of Texas,” said executive recruiter Charles A. Skorina, president and chief consulting partner of Charles A. Skorina & Co., San Francisco.

“The top four CEOs or CIOs of the largest Canadian pension plans each made more than $3 million a year. I can't imagine that the U.S. pension plan pay scale can change, given the funding situation, Mr. Skorina said.