Internalisation: the end of the world as we know it?

Many of Australia’s largest super funds have been progressively increasing headcount in their internal investment teams. Some have very rapidly built out their teams – although this is more the exception than the rule – and AustralianSuper is the first with an internal investment team of more than 100 staff. Asset managers are wondering: how much of their institutional business will be lost to internalisation?

Internal investment team headcount, 2013 – 2014

Source: Tria CIO Study, 2013 and 2014

The good news is that increasing headcount doesn’t necessarily mean funds are undertaking major internalisation programs. In fact, other than a handful of institutions that are expanding rapidly, headcount increases are gradual and conservative, and there is a heavy weighting to operational (middle- and back-office) roles. This reflects high awareness amongst funds of the up-front costs of internalisation and the new risks being introduced.

Only a handful of not-for-profit funds are extending their program to include internalisation of equities capabilities. Of those that have internalised investment capabilities, most have focused their resourcing on unlisted asset ownership (property and infrastructure) and cash management. There is a continuing role for an asset manager in the operational management of unlisted assets, but on much less favourable terms than which prevailed in a pooled vehicle. Historically this has been one of the most profitable product categories for asset managers, which means that although internalisation has not run far yet, the margin impact is already material.

So asset managers can’t afford to ignore the trend. The institutions with significant, active internalisation programs are also some of the biggest. The impact will be concentrated but significant, and increasingly so. As with unlisted assets, it’s not a surprise that the most profitable asset classes are usually candidates for internalisation, subject to the degree of difficulty of doing so.

While the cost reduction incentive for funds is strong, it will be years before we know whether members are any better off in net terms. Internalisation may simply create the next generation of captive asset managers (managers created by institutional investors to manage investments solely for those investors), which would present an entirely new set of challenges for not-for-profits.

Many captives are mediocre – low cost but adding no value. At the other end of possibilities, a number of today’s large and successful asset managers started as captives. Over time those captives outgrew their investors and started to operate on a more commercial basis, including managing third party money.

Both possibilities pose significant issues. The risk of mediocrity is high. But where internal teams are successful, less real or perceived dependence on internal FUM will increase the bargaining power of investment teams and places upward pressure on remuneration, fees, and elevates the risk of departure; diluting the very benefits internalisation was designed to deliver.

In the short to medium term the institution enjoys the effects of a low cost base and a manager they can directly oversee. But in the longer-term, diverging interests mean that neither the captor not the captive are particularly satisfied, and they are usually spun-out in one form or another.

So, will it continue? If history is any guide, the larger players will likely continue to internalise.

This is supported by our discussions with CIOs and senior staff at institutions with major internalisation programs. They reported positive results, and plan to continue the internalisation strategies in place. This means larger allocations to internal teams and encourages further exploration of asset classes suitable for internalisation.

Institutions who may not have considered an internalisation strategy are watching closely and may be encouraged to develop their own plans. But many remain cautious, waiting to see how the risks play out. The first ‘blow-up’ will bring the downsides to front of mind.

Like any market where buyers integrate back up through the value chain, the extent of the internalisation trend will depend on whether asset managers can prove they are continuing to add value: through differentiation, expertise, cost efficiency and risk management.