Rising interest rates, ESG concerns and new regulatory demands around cybersecurity are prompting retirement fund executives to bring an increasing proportion of assets under in-house management.
In the latest wave of insourcing — a trend that has been going on for the last 10 years — some assets owners in Europe and Australia are reducing the share of portfolios run by external money managers, citing sustainable investment regulations, cost pressures and the fact that, with a more favorable environment for fixed-income returns due to higher interest rates, it’s just as fruitful to do it themselves.
Asset owners in Europe this year are beginning to set sustainable investment key performance indicators for their own portfolio reporting under the European Union’s Sustainable Finance Disclosure Regulation. These KPIs must specifically state how portfolios may affect the environment.
Sources said these new ESG requirements will require funds to rethink the roster of managers to keep their ESG reporting and ESG objectives consistent across portfolios, which could involve culling managers that aren’t providing needed data fast enough.
Retirement fund executives are also facing a new requirement under the EU’s Digital Operational Resilience Act, which became effective in January and requires that investment firms strengthen their IT security, including greater oversight of suppliers to help improve cybersecurity.
Examples of retirement funds that have recently moved or are moving some asset classes in-house include:
- The 407.1 billion Swedish kronor ($40 billion) AP2, Gothenburg.
- The A$68 billion ($45.9 billion) Cbus Super, Melbourne.
- The 416 billion Danish kroner ($61.5 billion) Danica Pension, Copenhagen.
- The €53.7 billion ($59.2 billion) PKA, Hellerup, Denmark.
Recent increases in interest rates are one of the factors bringing investors back to traditional investments in local markets.
Low interest rates in the past few years have been a “powerful determinant of institutional outsourcing,” said Richard Bruyere, Paris-based managing partner and co-founder of consultant Indefi Group, in a telephone interview.
Mr. Bruyere added that the move by central banks to combat the effects of COVID-19 with massive amounts of liquidity pushed rates further down, forcing investors in recent years to look for other sources of higher yield — often in areas where they do not have the necessary skill set in-house to invest, he said.
But, now that interest rates are back at a higher level — improving yield for fixed-income investments, Mr. Bruyere said “the focus is on traditional investments that are easier to do in-house.”
Sources agreed that reducing costs continues to be a structural driver behind internal management — a trend that has been underway since the global financial crisis.
John Simmonds, head of business development U.K. and Ireland at Toronto-based cost and performance data company CEM Benchmarking Inc., noted that returns of internal vs. external teams on a gross level are similar across equity and fixed income, but internal management teams on average outperform external management teams on a net basis because of costs.
For example, CEM Benchmarking’s data for 2022 shows that the cost of managing a global equity fund in-house by asset owners is on average 17.5 basis points vs. 41.7 basis points if outsourced.
In fixed income, he said, the in-house teams’ costs are at 8.6 basis points compared with 22.2 basis points if the management is outsourced.
But while managing assets in-house is cheaper, for pension fund executives in Europe, costs are no longer the only consideration.
AP2 recently terminated three portfolio managers that were running about 2% of its assets in active China A Shares, deciding instead to bring the exposure under its in-house emerging markets allocation.
“It’s not only a cost issue. It’s also about what we believe will be most efficient in the long run on a holistic level and about having our own approach to sustainability and climate risks in the portfolio,” said AP2’s CIO Erik Callert, based in Stockholm.
Mr. Callert added that AP2’s China investments are now part of its emerging market portfolio, in which AP2 has a multifactor approach in the selection process of companies. “We prefer sustainable companies with high expected returns based on well-recognized quantitative factors,” he added.
“We focus on the most important companies to gain economies of scale. The public assets are primarily managed in-house, and we realize synergies by using the same team in the quant-based management of equities and fixed income, for example,” he said.
“On the private market side, like private equity, real assets, and private debt, we find scale through collaborations with partners or asset managers,” he added.
Mr. Callert said that AP2 decreased the share of total assets managed externally to 15% from 20%, adding that all of the fund’s listed stocks and bonds are now managed internally.
In Denmark, PKA is now building out its new in-house real estate unit to ensure that the fund’s local commercial and residential real estate investments are managed with social responsibility and that buildings meet green investment standards, according to Henrik Dahl Jeppesen, the new head of PKA Ejendomme, the unit that runs the asset management of directly owned Danish real estate.
Mr. Jeppesen joined the €53.7 billion pension fund in February and is leading PKA Ejendomme’s efforts — a team that is set to grow over the next two years. The initial investment in direct real estate made by the in-house unit is 27 billion Danish kroner, or about $4 billion.
Danica Pension also took some of its external investment mandates in-house during 2022 as part of the fund’s long-term investment strategy, a spokesman confirmed. Further details were not provided.
And Cbus Super, a superannuation fund focused on employees in Australia’s construction and building trades, on May 16 said it will further boost the portion of its portfolio managed in-house over the coming five years. Kristian Fok, the Melbourne-based fund’s acting CEO, said in a news release that Cbus’ new strategy calls for raising the portion of its portfolio managed in-house to 50% from 38%.
Mr. Fok said the fund was at an advantage in being able to use existing teams to search for value without the need for costly and potentially risky investments in global offices.
In Europe, according to consultants, SFDR could end up prompting asset owners to further part with their managers.
Edwin Massie, senior consultant at Ortec Finance Ltd. in Randstad, Netherlands, said in a telephone interview that SFDR requires further internal management of assets because managers have to make integrated ESG reports for all asset classes — and some may not moving fast enough for pension funds to meet their own timetables. “Right now, it is the first cycle of SFDR reporting and I think frontrunners and laggards among the managers are going to show up,” he said. “If managers are not able to deliver what is required by pension funds, it could be a trigger to terminate,” he said.
Under the latest wave of SFDR, known as Level 2 rules effective Jan. 1, managers must declare any principle adverse impact of their investment strategies — how their portfolio may affect the environment — for example if their portfolio companies damage biodiversity where they operate.
At the same time, investors in Europe are beginning to require much more in-depth disclosures under Level 2 rules, so they can report on how their investments contribute to carbon emissions or create water pollution.
But ESG regulation is not the only regulatory pressure that could have an impact on in-sourcing assets in the coming years, Mr. Massie said.
De Nederlandsche Bank, the Dutch central bank and general pension fund supervisor, is pushing pension funds to have better control over critical outsourced functions to better monitor non-financial risks, he said.
“We see the regulation of oversight, for example IT oversight, increasing,” he said, noting that now pension funds under the new act have to monitor the cybersecurity practices of the companies to which they outsource.
