Sovereign wealth funds such as ADIA are managing more of their money internally. George Mitton
reports on a worrying trend for external asset managers.
The annual report from the Abu Dhabi Investment Authority (ADIA), one of the world’s biggest sovereign wealth funds, includes lots of information without giving away the one thing everyone wants to know.
You can read how many employees it has and how many nationalities they represent, but you’ll have to guess how much money is in the fund.
Yet this year, the annual report did turn up an eye-catching finding, albeit one that perturbed asset managers in the region. Between 2013 and 2014, ADIA took back a tenth of its assets from external managers to manage in-house.
An annual study of sovereign wealth fund behaviour commissioned by asset manager Invesco suggests ADIA is not an isolated case. In fact, sovereign wealth funds across the world seem to be ‘insourcing’ a bigger proportion of their assets than before. If this trend continues, it will mean more competition among asset managers for a shrinking number of institutional mandates and increased rivalry for staff as the funds seek to recruit top employees.
How significant is ADIA’s insourcing move? ADIA does not disclose its assets under management so the following is speculative. However, the Sovereign Wealth Fund Institute, a US-based consultancy, suggests the fund has $773 billion.
If the estimate is accurate, ADIA’s latest round of insourcing has withdrawn something like $80 billion from external managers. Supposing an average fee of 50 basis points on these assets, the collective lost revenue to external managers would be about $400 million, roughly the entire annual revenues in 2014 of Ashmore Group, a mid-sized asset manager with $75 billion under management.
The evidence suggests ADIA is not the only sovereign wealth fund pursuing an insourcing programme. The Invesco report suggested funds reduced their proportion of externally managed assets in four out of six asset classes last year.
In some cases, the fall was dramatic. Sovereign wealth funds insourced a tenth of their global real estate allocations between 2014 and 2015, according to the survey, which is based on interviews with staff at sovereign wealth funds around the world. Across global equities, global bonds and cash, the proportion held by external managers also fell by as much as six percentage points in the year.
The insourcing trend is not new. The Invesco Global Sovereign Asset Management Study describes “a decades-long shift to developing in-house asset management capability”.
However, the survey suggests the trend is accelerating, with the fall in externally managed assets generally bigger between 2014 and 2015 than in the previous year.
Why do sovereign wealth funds want to insource? Partly because they believe they can lower costs without compromising performance if they manage their portfolios themselves. This view became widespread after the financial crisis, when institutional investors suffered heavy losses and began to doubt that their investment providers were providing value for money.
Another reason concerns reputation. “They want to be seen as good at it,” says Nick Tolchard, head of international development at Invesco and the man who oversees the annual study. “To bring more assets in-house is a sign of self-confidence.”
Tolchard says this year’s survey, which included 59 sovereign funds, measured a rise in funds’ self-assessed abilities to manage risk and mitigate downside. Sovereign wealth funds believe they are getting better at managing their investments. Accordingly, they want control
Another factor makes the insourcing trend feasible: passive investing. With the growth of investment strategies that track indices, it has become easier than before to manage money in a transparent, cost-effective way. Although interviewees in the Invesco survey are not asked about their fund’s split between passive and actively managed assets, Tolchard says he thinks it likely the majority of the money ADIA insourced last year is now being managed in passive strategies.
Supporting this claim is the increasing number of customised indices that Gulf sovereign wealth funds are using internally.
“We used to do a handful of custom indices across the region,” says Robert Ansari, head of the Middle East for MSCI, which has some $9.5 trillion benchmarked against its indices worldwide. “The number of custom indices has almost tripled in the last three years.”
Sovereign wealth funds may want a customised index to screen out securities that are not sharia-compliant or to reduce exposure to the petrochemicals sector, for instance. The result is the same: more control, which allows the sovereign funds to manage more money themselves.
Another trend could accelerate this shift to passive investment. ‘Smart beta’ means using unconventional indices to gain exposure to specific investment factors (such as ‘low volatility’ or ‘quality’ in equities).
Like other index providers, MSCI offers a range of smart beta indices, which it calls factor indices. Ansari says Middle East sovereign wealth funds have yet to invest significant sums in smart beta, but are pouring resources into research.
“We thought clients would be quick to adopt factor indices and go in with a splash,” he says. “It seems clients are taking longer to understand factor investing in a more detailed way and are in turn doing larger investments when they do.”
If Ansari is right, there could be another wave of insourcing on the horizon when sovereign wealth funds realise they are capable of managing smart beta investments themselves.
In recent years, sovereign wealth funds have even built up internal teams to invest in asset classes, such as real estate, that had been considered the preserve of specialist external managers. Some of the largest sovereign funds have offices in foreign cities, such as London or New York, where staff manage the fund’s local properties.
However, there is some hope for external real estate managers, because it seems the sovereign funds still require external expertise if they want to broaden their property portfolio beyond a few foreign cities, or if they want to invest in infrastructure such as airports.
Anthony Fasso, international chief executive for AMP Capital, an Australian alternative investment firm, says even the biggest sovereign wealth funds face constraints when they seek to expand beyond straightforward property deals.
“These sovereigns can’t be in every city,” he says. “Often, they’re constrained by headcount.”
In addition, many properties require ongoing management. The owner may have to attend board meetings and oversee regulatory matters (in such cases, it is convenient for an external asset manager to represent the owner). The obligations are onerous in the case of large infrastructure investments, where external managers still play an important role, says Fasso.
Fasso adds that external managers offer another service: they are good at finding deals in the mid-market, while the funds themselves have a tendency to chase trophy assets.
“It’s a coverage game,” he says. “If you’ve got a small team and a lot of capital to deploy quickly, you’d probably go after the large transactions.”
Given that external managers still have a role to play when it comes to alternative asset classes, it must be comforting to know a survey of European institutional investors by investment consultancy Mercer found the average allocation to alternatives rose two percentage points in the past year to 14%.
External managers say they can also provide a valuable service when it comes to complex forms of investment such as multi-asset funds. The sovereign wealth funds may also appreciate help with tasks such as risk analysis and tactical asset allocation.
Tolchard, of Invesco, says there are still many ways to work with sovereign wealth funds, however, managers must be flexible.
“The days of being a component provider, winning RFPs [requests for proposal] and managing individual mandates are over,”
“The direction of travel is to work in partnership to enable funds to achieve their asset allocation goals.”
A consequence of this move to a “partnership” model is that sovereign wealth funds seem to want to reduce the number of firms they’re working with. This makes sense. If they can do more themselves, they will only want to work with the handful of external managers that can do things they can’t do internally.
This trend has been observed at other institutional investors.
In July, the body that manages the New Zealand Superannuation Fund, worth 29 billion New Zealand dollars ($19 billion), said that it was expanding an existing mandate with Northern Trust.
“The appointment is consistent with our desire to have fewer, deeper manager relationships, helping us manage the fund’s portfolio as efficiently as possible,” says Matt Whineray, chief investment officer for the New Zealand Superannuation Fund.
The key words are “fewer, deeper”. The pension fund wants to reduce the number of its providers, but wants a stronger relationship with the ones it keeps.
If the trend continues, it will concentrate assets in the hands of a smaller number of external managers. It’s notable that not only does Northern Trust provide both equity and bond mandates to the New Zealand fund, it also provides custody. These kinds of many-layered partnerships could well become the norm.
The upshot of the “fewer, deeper” trend is that the asset managers best placed to win new business from sovereign wealth funds are those that already have relationships with them. These managers will increasingly promote themselves not as mere external managers but as partners to the funds, and will try to offer a range of services including asset allocation advice.
The increasing popularity of alternative asset classes should provide a role for some small firms too, notably specialist external managers in asset classes such as infrastructure.
The firms to suffer could be the mid-sized asset managers, which are too small to offer the kinds of full-suite offerings that BlackRock or Northern Trust can provide, but not sufficiently specialised to operate in any of the niche asset classes where the sovereign funds need external expertise.
As of 2014, ADIA says 65% of its assets are managed by external managers, down from 75% in 2013. Will this figure fall to 55% this year? Could there be a point when ADIA manages nearly all of its assets itself?
It is hard to be certain, but there are hints that ADIA, at least, doesn’t have that in mind.
In his introduction to the annual report, Hamed bin Zayed Al Nahyan, managing director of ADIA, hinted that the recruiting drive necessary to build up the fund’s internal investment capacity was nearing completion.
If that is true, the insourcing trend may be nearing completion too. ADIA seems not to be an isolated case. Tolchard of Invesco says the general recruitment drive among sovereign wealth funds “seems to be plateauing”.
That is some encouragement to external managers. However, don’t expect any funds to unwind their internal capacity.
Once internal capabilities are built, they tend to stay, one reason being that reversing them generally means laying off staff. In the words of the Invesco report, “it is always easier to build new internal capability than to unwind internal structures and issue more external mandates”.
Yet external managers should not despair. Sovereign wealth assets are likely to rise. Admittedly, the Gulf funds can expect asset growth to slow, if not stop, because of the low oil price. With a barrel of Brent crude currently trading at less than $50, less than half the high point seen in 2014, and plenty of costly infrastructure projects to be paid for, there is less money left over for ADIA, the Kuwait Investment Authority or the Saudi Arabian Monetary Authority.
But it seems unlikely that the oil price will stay at its current low level indefinitely.
Most observers expect more money to flow into the Gulf sovereign wealth funds in time. The proportion of assets held by external managers may fall, but if the overall pie is growing, asset managers can continue to do profitable business in the region.
The key, for asset managers, may lie in positioning themselves as valuable partners to the funds and not merely external – and dispensable – providers.
©2015 funds global mena