U.S. Funds Building Up Internal Management Operations

More public funds across the U.S. are looking to save on management fees and exert better control over their portfolios by handling investments in-house. The Oregon Investment Council (OIC) is the latest fund to jump into internal management and, pending the passage of a new legislative bill, expects to internalize its public equities and fixed-income investments. Other large funds, however,  are bolstering their existing investment capabilities to include alternative asset classes, signaling a sharp shift from the traditional practice of most U.S. funds.

The fate of the OIC, which has a $79 billion investment portfolio that includes the $61 billion Oregon Public Employees’ Retirement Fund, rests on the Investment Modernization and Cost Reduction Act. Filed in January by State Treasurer Ted Wheeler, the bill would transform the OIC into a corporation, allowing it to hire more staff for internal investment operations. The OIC currently manages about $153 million of its investments in-house, but that number could jump to almost $17 billion if the new legislation is approved and the fund is able to internalize its public equities and fixed-income portfolios.

The Senate began public hearings on the investment bill on March 11. Neither Governor John Kitzhaber nor legislators have yet indicated publicly whether they are for or against the bill, but Oregon has a history of converting state agencies into corporations: the State Accident Insurance Fund was converted in 1980, and the Oregon Health and Science University made the switch in 1995. “I think it has a reasonable chance of passage,” said Keith Larson, chairman of the OIC. Larson, who testified before the State Senate on March 11, said that the bill would not only cut the fund’s costs, but could boost its returns and allow for better governance. “We’re trying to better align the responsibility to manage with the authority to manage,” he said.

Adding Alternatives

Ranked as the 11th-largest U.S. public fund by iiSEARCHES, the OIC is an outlier among its peers, most of which handle a healthy portion of their investments in-house. The $253 billion California Public Employees’ Retirement System, for example, internally manages 65% of its portfolio. The $128.6 billion Florida State Board of Administration handles 41.5% of its portfolio, while the Teacher Retirement System of Texas manages 76.3% of its $112 billion fund. Other large funds, including the California State Teachers’ Retirement System, the New York State Common Retirement Fund, and the State of Wisconsin Investment Board, also manage parts of their portfolios in-house, although most stick to public equities and fixed-income investments.

Some, however, are beginning to expand into alternative asset classes like private equity, real assets, and real estate. In 2009, Texas Teachers launched an in-house program that targets specific opportunities in private equity and real assets. Through the program, the fund has invested $4 billion in the two asset classes, primarily through direct or co-investments. This year, it plans to commit an additional $800 million.

The Pennsylvania Public School Employees’ Retirement System (PSERS) has taken it one step further: in 2011, the $50 billion fund created its own risk-parity program, which now manages a $200 million allocation. It also handles about $450 million in gold futures, and last year it moved some of its emerging markets equity investments in-house.

“Having an alternative investments program is perfectly fine, as long as you have a large enough staff to properly manage the program,” said Pete Keliuotis, managing director at consulting firm Strategic Investment Solutions (SIS). “ Our rule of thumb is that once you exceed 25 partnerships per staff member,  it becomes quite difficult to monitor existing investments while at the same time looking for new investments.”

The OIC, which has about 23% of its portfolio invested in private equity, would not look to bring alternative investments in-house, Larson said. “You need to determine where you have core competencies, and use those as the strength for your internal management,” he explained. It’s hard for asset managers to generate alpha from large-cap public equities investment, Larson said, which is why it makes sense for public funds to manage such investments on their own. But “you would need a lot more resources and a lot more skill” to manage private equity investments, he said. “To think that you’re going to outperform a top [private equity] fund manager would require a hefty ego.”

Not everyone agrees. “If you had $130 billion, wouldn’t you own a building?” said Larry Schloss, chief investment officer of the $130 billion New York City Retirement Systems. “But we don’t own anything outright — all of our real estate investments are made through funds.” Schloss has long been pushing for internal management at his fund, which is the fifth-largest public fund in North America by asset size, according to iiSEARCHES. It currently manages none of its investments internally, something that Schloss would like to change. By managing their own investments, Schloss said, pension funds can save on management fees and boost returns. “It’s trying to be more nimble,” he said.

The Benefits

Cutting costs is the primary motivation for pension funds to move investments in-house. In 2012, Pennsylvania Public Schools saved about $8.3 million in management fees, according to a spokesperson for the fund, while its internal investment team added $59 million in additional investment income. The $88.1 billion New York State Teachers’ Retirement Association, meanwhile, noted in its 2012 annual financial report that that expenses for its externally managed portfolios were 57 basis points annually, while its internally managed portfolios cost only five basis points.

If the Oregon State Legislature passes the bill and the OIC can move some of its investments in-house, it could save $12-13 million in management fees each year, according to spokesman James Sinks. One consultant, he said, estimated that the fund’s savings could reach $90 million.

But there are other motivating factors. “We see the primary benefits of internal management as, obviously, lower costs,” said Dennis MacKee, spokesperson for the Florida State Board of Administration, which manages about $53.33 billion of its assets internally. But in-house management, he added, also “keeps our staff engaged in the market, which has the added benefit of facilitating our oversight of external managers, and it affords greater control.”

‘Political Hot Potato’

To successfully manage investments internally, however, public funds need to have the right capabilities, which often translates to the right people. But most public funds can’t offer the kind of pay that private asset managers can, which means they either have to raise their salaries or accept a less-talented investment staff.

“That’s the hindrance,” said Schloss. “If you’re going to do internal management, you’re also going to need to pay more than you currently pay.” The money that a fund would save in management fees, Schloss said, would more than pay for a larger investment staff. But “it always becomes a political hot potato,” he said, to suggest raising paychecks.

With the Investment Modernization and Cost Reduction Act, the OIC has found a possible route around this roadblock. By turning the OIC into a corporation, the new bill would place the council’s hiring and staffing decisions in the hands of a board of directors, rather than the legislature. This would make it easier for the OIC to create a strong investment management team and increase its risk management and support staff.

Some U.S. funds have been looking at Canada, where most large public pension plans internally manage almost all of their investments. The $172.6 billion Canada Pension Plan Investment Board employs more than 800 people to handle 85% of its portfolio, and has offices in Toronto, London, and Hong Kong. The $60.8 billion Ontario Municipal Employees’ Retirement System, meanwhile, manages  88% of its investments in-house.“The large Canadian plans have moved to a different model,” said Keliuotis. “They’re making their own direct portfolio company investments within infrastructure, real estate, private equity — oftentimes they’re not going through funds to make those investments. Instead, they’re essentially competing with asset managers.”

While few believe that U.S. funds will adopt the Canadian model in its entirety, parts of it may spread below the border. “I think we’re going to bite off pieces where we think they make sense, and implement them in a way to make sure that we’re still staying under control,” said Larson.

Article originally appeared in Money Management Intelligence and Global Money Management Quarterly. Link to MMI version here (paywall).

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