By Ciaran Barr
Last time I discussed the importance of control and flexibility in investment arrangements in u ncertain times. A key part of this is cost, an unavoidable part of doing business, but one that can easily be mismanaged.
The simplest approach to costs is to keep them as low as possible and for many, moving to a completely passive portfolio in liquid public markets – whether implemented internally or externally – would be consistent with cutting the cost base to the minimum. However, for many institutional asset owners with specific investment targets, the level of return on offer in passively managed public market portfolios is likely to be insufficient. If we accept that as a premise, how can we best manage costs? We believe there are three issues to consider.
Firstly, the asset owner needs to decide what it is worth paying external managers for. In short, it is likely to be what the asset owner cannot achieve by themselves. Investors that used to pay for actively managed ‘alpha’ can now replicate the risk premia embedded in their portfolios at significantly lower cost using a mixture of derivatives, indexing and internal management. We are doing this with much of our hedge fund exposure and actively managed equities. Hedge funds can often be replicated using bond (duration and credit) and equity risk premia – and actively managed equities with biases towards non-market capitalisation exposure such as value, quality, low volatility and so on.
Secondly, the asset owner must weigh up the balance between internal and external management. This is partly a function of scale whereby larger asset owners can benefit more from economies of scale when undertaking more complex investments such as direct ownership of assets in private markets. However, it is also dependent on the stability of portfolios. Given the fixed costs involved in hiring and running an internal team, it only makes sense to do so when the asset class/risk premia involved is largely expected to be a permanent part of the portfolio mix. It will only be a small number of asset owners where it is efficient to internalise all aspects of investment arrangements.
Thirdly, the asset owner must fully understand both total costs and what returns these costs are expected to deliver. This is achieved by considering two dimensions sometimes overlooked: measuring all costs, including hidden fees, and assessing ex ante the value-add from the investment mandate, whether internal or external. Our own analysis has estimated the total costs paid by Railpen on the aggregate portfolios in the past were higher than the headline figures, largely due to hidden charges in private markets. It is also important to model the expected returns – and range thereof – from a given investment to enable a judgement to be made on whether the expected value-add after costs produces a fair division between the asset owner and asset manager.
Given the challenges facing schemes, and the potential benefits for both employers and savers, asset owners should ensure these issues have been fully analysed and given careful consideration.
Ciaran Barr is an investment director at Railpen
