Buy or build?

Some European funds have traditionally managed assets in-house for cost-effective long-term performance. Gail Moss assesses the do-it-yourself approach

Despite the widespread use of specialist managers, many European pension funds continue to manage money themselves. A key factor behind this is the issue of long-term performance.

"Our policy is to manage in-house any asset class we have the capability to do so, where it is cost-effective," says Elizabeth Fernando, head of European equities at the Universities Superannuation Scheme (USS) in the UK. "We believe in-house managers are generally better placed than external managers to deliver long-term performance. Academic research suggests in-house funds outperform externals over the long run."

The reasons for this are, firstly, that the in-house managers' time horizons are aligned with those of the trustees.

Fernando says: "We can invest for the long run without worrying about quarterly performance, so the illiquidity premia can be captured, and we can take advantage of dislocations in the markets caused by fear or herd mentality, rather than fundamental factors."

Furthermore, she says that USS is not bound to a house style or investment policy, but encourages managers to run money in the way they think best. That means none of their strategies have to fit into neat marketing boxes.

The somewhat homogeneous nature of the fund, compared with other pension funds, is also conducive to in-house management.

"We have one fund with one objective, so all our analysis is geared to delivering that one goal," says Fernando. "For smaller schemes, economies of scale may make in-house management uneconomic, but given USS' size, our in-house cost base is extremely competitive compared with the management fees associated with outsourced funds."

For many schemes, a common practice is to split the portfolio into both internally- and externally-managed segments. In order to do this successfully, however, there are several issues which pension funds and fiduciary managers have to address.

"I believe the mix of internally and externally managed portfolios does work if you make transparent choices," says Wouter Pelser, chief investment officer, Mn Services, the Dutch asset manager which is owned by metal industry pension funds PME and BPMT, and has 18 institutional clients.

"You must be clear as to which parts you manage internally, and which externally," says Pelser. "For example, it does make sense to manage money internally for the hedging portfolios, such as investing in inflation-linked bonds, and in swaps."

He says it is also essential for pension funds to know the sectors - such as regional equity markets - which they intend to enter via internal management.

"The main criterion for internal managers to adhere to is that they can compare with the best in the world, ie, that performance is at the top of their peer groups," he says. "Furthermore, the internal asset management processes should be monitored in the same way as those that are externally managed."

One factor influencing the outsourcing of part of the portfolio to external managers is whether the assets are to be managed actively or passively. In general, active management is more likely to be handled externally.

At BVK, the Swiss pension fund for employees of the Canton of Zurich, the internal asset and real estate management covers just the active management of cash, domestic and foreign denominated straight bonds, mortgages and domestic real estate. All other investment categories - those which have to be managed actively or where a lot of expertise is needed - are managed by external asset managers or advisers. These include convertible bonds, indexed equity portfolios, private equity, commodities, hedge funds and foreign real estate. BVK has also outsourced its whole custody and settlement administration business.

Claus Stampe, (pictured right) chief investment officer, PensionDanmark, says: "In general terms, we prefer internal management if we are convinced that we are able to manage the mandates as well as the best external managers out there. We therefore manage about a third of our equity investments in-house in passive or enhanced mandates, while all active equity mandates are managed by external managers. On the fixed income side, we manage all our investment grade exposure in-house in active managed mandates, while investments in FX, high yield, EMD and leveraged loans are outsourced."

Hermes, however, the asset manager set up originally by BT Pension Scheme (BTPS) which now offers services to external clients, is doing things the opposite way round.

"The in-house model only works if trustees and the executive are fully aware of the imperative to deliver best advice and best execution," says Rupert Clarke, chief executive officer. "With the consolidation and specialisation of the asset management industry over the last 10 years, it is almost inconceivable that an in-house team can deliver best execution in all asset classes."

It is for this reason that Hermes has progressively transferred a number of the more passive asset management mandates to third parties over the past few years, and committed to  on investing in more niche areas where it has an established track record or where new specialist teams can be identified to meet BTPS's evolving needs.

"At Hermes, the governance disciplines we have established to ensure that this works effectively involve a very clear internal separation of the responsibility to advise on and manage all the needs of the fund, effectively the executive function of the fund, from the asset management activities," Clarke says. "Separate compensation structures for each of these teams have also been put in place to reflect and align the teams to meet the different objectives of each side of the business."

ATP, the largest Danish fund, has run an in-house investment operation for years, but is increasingly separating off the management of its liquid assets from the outsourcing of non-liquid assets.

"In terms of the portfolio structure and implementation of structures in liquid markets, we think we are capable of doing that ourselves and hiring the right people to do so," says Bjarne Graven Larsen, (pictured left) chief investment officer, ATP. "But for private equity, real estate and other non-liquid markets, we have set up our own fund of funds but don't have the right skills to invest directly," Larsen says. "So what we have set up is an operation to select the best managers. We believe we can run our liquid assets better than external managers, and at lower cost. "

Another factor in outsourcing is whether the pension fund can build up enough of the required skill sets for managing its portfolio by employing its own specialists.

And it seems that recruitment is either a virtuous or a vicious circle.

"It's important that your company has the right exposure," says Pelser. "Our success means we have an established place in the labour market. That makes it easier for us to hire talented people and build talented teams. And in some sectors, the fact that the market is turbulent gives us even more of an opportunity to hire good people." But he says that the key to retention is to reward the people who are creating success: "Differentiation in retention is becoming more and more important."

Fernando says that pension funds engaged in managing their own portfolios can make themselves more attractive by their culture, with a recent USS advert for a graduate trainee attracting over 200 responses. "The investment freedom, early responsibility employees are given and the flat management structure at USS have attracted high-quality personnel in all areas," she says.

She adds that pension funds can also help themselves by taking a flexible attitude towards the specific hires they make. While USS has a buy versus build decision for new areas such as alternatives, it nevertheless recently strengthened its alternatives team with two new appointments.

"Winning the war for talent is critical to success in asset management and there are many factors we regard as being the most important when dealing with the recruitment and retention of personnel," says Paul Trickett, European head of investment consulting, Watson Wyatt.

Like Pelser, Trickett advocates a culture that recognises, encourages and rewards independent creativity. Trickett says that other must-haves on any pension fund's shopping-list include a culture of talented, experienced and motivated investors, given freedom to express flair; a policy of focused decision making, with clear accountability; and thoughtfully-constructed teams with complementary skills, experience and personalities.

"Leadership is also vital, as is the crucial role played by CEOs and CIOs in the continuously changing investment management industry," he says. "The issue of teamwork is also interesting. Some of the greatest investors of the past have appeared to work on their own rather than in a large team. However, it should be noted that most of these people built up a large network of people to discuss ideas with, so even in one-man organisations, we believe a thorough understanding of how the key individual works within a wider group is essential."

However, some pension funds find their legal status hinders recruitment of in-house staff. "Because BVK is still not an independent legal entity but a department of the directorate of finances, recruitment of additional personnel is restrictive, salary policy is not very flexible and career opportunities are often quite limited compared with the financial industry," says Daniel Gloor, head of asset management at BVK. "Therefore it has always been difficult to hire asset management professionals for in-house management."

Richard Gröttheim, executive vice president of AP7, the Swedish public pension scheme, sees a related reason for outsourcing most of the fund's asset management. AP7 employs a core group of people responsible for asset allocation and hiring managers, outsourcing the asset management apart from some of its Swedish equity and bond portfolios.

"We can't achieve best in class returns by ourselves, and outsourcing gives us a better standard of management," says Gröttheim. "But it also gives us better flexibility. It is easier to hire and fire an outside manager than an in-house team. It is also better for relationships, as you can deal with external managers on a more arms' length basis."

Whether the entire portfolio, or just part of it, is outsourced, the relationship between the pension fund and its fiduciary manager poses several challenges. "The relationship works very well if there is professional staffing within our clients, and we can work very well within the controls of clients and their investment committees," says Pelser. "It is also positive to have a professional counterparty for discussion and for monitoring. And I think it's very important for the client to monitor us."

He adds: "It is important to have a blueprint of the responsibility structure, so that everyone knows what the pension fund office is doing, and what the investment committee, consultants and fund managers are doing."

There may also be specific areas where it is particularly important to keep a tight rein on fund managers, for example, socially responsible investing.

"We blacklist certain companies through our SRI policy, and have set up a compliance system to ensure our external manager refrains from investing in them," says Gröttheim.