Superannuation investment management - is it better in-house?

Emma Rapaport, editorial manager, Morningstar Australia contributed to this article.

The way superannuation funds invest their members’ retirement savings is undergoing a significant change. Whereas large funds historically outsourced management of their investments to external fund managers, under the guidance of an asset consultant, today more and more are bringing expertise in-house, building out their own internal investment management teams.

AustralianSuper was one of the first to kick-start this trend in 2013, establishing a hybrid model with investment management duties shared between internal and external teams, but the trend has since spread to other large funds like Cbus and UniSuper. Aware Super is reportedly hiring at least 70 into their investment team. At AustralianSuper, approximately 44% of assets are managed internally by around 200 employees, a recent review undertaken by Morningstar showed. The fund expects to grow this figure to 60% in the medium term. At Cbus, 37% of assets are run internally at Cbus by 115 investment staff.

This trend has emerged over the last decade and is certainly not exclusive to Australia. For example, Ontario Teachers’ Pension Plan, a large Canadian pension fund, manages 80% of its $250 billion of assets in-house.  

Super industry insourcing snapshot:

Source: Based on fund's latest annual report and website information

The reasons for this activity vary between funds. A 2016 Centre for International Finance and Regulation study found some industry executives believe that in-house management can provide access to higher returns, while others consider the ability to tailor investments to be of prime importance. Report co-author Geoff Warren says in-house management can also address capacity constraints as funds under management grow. Cost-control is also a key consideration. Australians spend more than $30 billion in super fees every year (excluding insurance premiums), according to the 2019 Productivity Commission review into superannuation. That's money that could be funding a better, more adequate retirement. Funds are now under increasing pressure to reduce their fees following initiatives like the Australian Prudential Regulation Authority 'heatmap' and the Your Future Your Super reforms. One-way funds can seek to lower fees is by bringing investment management in-house. However, this is a costly exercise, forcing funds to proactively pursue mergers, creating efficiencies and economies of scale.

Not all funds have jumped on the trend. Scott Hartley, ex-chief executive of Sunsuper told the Financial Review in 2019 that he is "very sceptical" of bringing investment managers in-house. To reduce costs, the fund has sought to shift a sizeable portion of its equities into passively-managed funds. Hostplus has similarly chosen to stick to external fund managers.

The insourcing of investment management has been a hot topic within the Australian superannuation industry for several years, but should members also take notice? I believe yes. With the superannuation sector forecast to be worth $34 trillion in 2061 dollars, 10.6 times its current size, it pays to keep an eye on how this money is being managed. As funds face increased regulatory scrutiny, greater focus is being placed on demonstrating consistent outperformance, forcing funds to reconsider their investment strategies. For investors, ongoing monitoring is crucial as the insourcing trend adds an additional layer of complexity.

Let’s look at some of the pros and cons of insourcing investment management.

Benefits: greater control, lower fees

Increased control of the total portfolio

In-house investment management provides considerably more control as the fund is better able to respond quickly to market movements at a total portfolio level and integrate environmental, social, and governance considerations at every point in its investment process. Further, large funds looking to place money with external managers can face capacity issues--the external manager won’t manage the required amount for the super fund due to the business risk of a single large client or the potential alpha diminution from managing too much. Owning scarce assets (think Sydney or Heathrow airports) directly can also be very attractive for these long-term asset owners. It often supports a much longer-term ownership horizon than if the super fund invests through an external investment manager who is managing a fund with a 10-year (or less) time horizon and needs to buy and sell the asset within that time frame.

Scaling up and fee costs

Lower fees have been high on the agenda for Australian investors for years and insourcing investment management can generate fee savings for investors. AustralianSuper estimates that its internalisation programme now saves members around $200 million annually. The fee savings are generated through two main mechanisms. The first is a result of substituting the payment of asset-based fees to external managers for largely fixed salaries to internal staff.

Let's take a relatively extreme example: If a large fund has an equities allocation of $50 billion and it pays, on average, 5 basis points per annum to an external manager, it is paying away $25 million per annum in investment fees. The other option could be to pay 50 people an annual salary of $250,000 each and reap some cost savings. 

External and internal investment management fees at $50 billion in funds under management

Illustrative example only

The magic is when additional scale is introduced and the $50 billion of equities grows to $100 billion. It is unlikely that a significant increase in staff numbers is required to manage these additional assets, and unless the 5 basis points of external investment management fees tiers down to 0 basis points, there are significant fee savings potentially available. Clearly in practice it is always a balancing act to ensure adequate resources are in place to continue to scale internal investment programmes and generate optimal outcomes for members--but the potential scale benefits are real. And this relatively extreme example highlights why AustralianSuper estimates it is banking large savings for members given the portion of its internally managed assets.

The other part of the equation is performance fees. Many private equity, infrastructure, property, and alternatives investment managers command lucrative performance fees for performance in excess of a benchmark. While in-house investment personnel may earn performance-linked incentive payments, they are often much lower in absolute terms and linked to the overall fund performance, which creates a better alignment with members.

Drawbacks: potential for poor performance

Fee savings and poor performance

While the fee savings available from in-house investment management appear dazzling at first blush, it’s worth considering how quickly these fee savings could be eroded by poor performance. Investment management is a tough game and, unless roughly equivalent levels of competence can be achieved, the potential loss from lower investment returns can quickly swamp any fee savings. Returning to our simplified example from above, at $50 billion in assets, annual underperformance of just 25 basis points results in $125 million of lost capital for members. And while the fund may be able to publish a lower investment management fee, investors eat net returns. This is a key reason why many funds are selective about the asset classes they insource--they want to internalise strategies where equivalent levels of competence with external managers can be achieved, and that is not necessarily achievable in every asset class.

Impact of lower returns from internal investment management at $50 billion in funds under management

Illustrative example only.

So, what are the results? Let’s use AustralianSuper as the case study. It has successfully lowered investment management fees for investors and delivered solid investment for members for the last five years. Based on the return data publicly available, it is impossible for us to know whether a fully outsourced model would have delivered better returns to investors, but prima facie members do not appear disadvantaged by the model.

AustralianSuper Balanced option investment fees and costs

Source: Morningstar Direct; AustralianSuper Product Disclosure Statements.
^As defined by AustralianSuper.

AustralianSuper Balanced option trailing returns as of 30 September 2021

Source: Morningstar Adviser Research Centre.

People and governance

The importance of good governance when insourcing investment management should not be underestimated. Internal investment teams need clear objectives, and performance should be measured periodically by both the trustees of the fund and independent assurance reviews. It’s difficult to evaluate investment decision-making over the short term, and it may take years to properly assess whether the internal team is delivering on its objectives. This begs the question of what happens when the internal team is not delivering to its objectives and needs to be terminated? Hopefully this has been contemplated by the trustees prior to insourcing and a clear plan is already in place--as it is not as simple as replacing one external mandate for another and raises a host of issues, including costly redundancy payments and internal cultural disruption.

Process and operational risks

Investment-process-related and operational risks should not be underestimated. The integration of internal and external management into a coherent investment process should be scrutinised carefully. And the supporting infrastructure required to adequately manage money is expensive to set up and can be costly for investors if not done well. External managers have often spent years refining their trading, compliance, technology, and back-office support systems. Internal teams need the same infrastructure, and trustees need to carefully oversee this part of the equation. After all, the contractual protections that come from external management no longer exist, and losses resulting from a large trading error will now be compensated by the fund’s own insurances or its reserves.

Conclusion

There’s a lot to like about insourcing, but it is not for every fund and investors should be aware of what can go wrong. While Morningstar holds some of these large super funds in high regard, considerable time is dedicated each year to reviewing the people, processes, parent, price, and performance of large superannuation funds. These funds are anything but a light touch from a due-diligence perspective.

Morningstar will continue to scrutinise the internal and external management team within these funds with a view to driving great outcomes for investors.

Morningstar's superannuation fund coverage:

Source: Morningstar