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My father’s table: Agency risk in internalisation

The scrutiny applied to internal managers rarely matches that applied to external managers, writes Rob Prugue. But underperformance is still underperformance, and if something goes wrong the member wears the risk.

When I was fifteen years old my best friend and I got ourselves into typical school boy mischief.  It was nothing major, but we were sent to the principal’s office and had to wait for our parents. My friend’s mother came first. The look she gave me – never mind that it was her son who got us both into trouble in the first place – was unforgettable.

This is what economist refer to as “cognitive bias”; using our own personal observations and beliefs to make conclusions. Cognitive bias is alive and well within our near A$3,500 billion superannuation market. The investment metrics we use to assess external portfolio offerings are often disregarded when (or should I say if) we asses our own capabilities and offerings.

A few decades back I had the great fortune to work in the international equity desk for New South Wales State Super, the pension fund for employees of the state. By today’s standards our assets under management would be considered small, but back then we were amongst the top five largest funds. Using our then economies of scale, State Super built an internal asset management arm for all the major asset classes, including unlisted assets, but outsourced satellite assets with a targeted risk/return profile. My team at State Super managed international equities and outsourced regional small cap and emerging market funds. Final overall global allocation was done by the team.

As is the case with funds today, we had to present to our board each quarter. Nearly all the formal conversations were directed at the external managers holdings – never mind that external funds only comprised about a third of the total international equity allocation. Discussions on the internal assets were more about the macro than the overall performance of members’ funds. They didn’t see anything wrong with this until a rogue trader in Singapore (Nick Neeson) pushed Barings Bank into bankruptcy. The Queen’s bank, as it was often called, had filed for bankruptcy in 1995. One rogue trader pushed this once notable institution, with over 250 years trading history, into bankruptcy.

Soon afterwards, the then treasurer of NSW informed the board at State Super that the state would put the entirety of State Super Investment Management Corp (SSIMC) up for sale. As the assets under management belonged to members , while SSIMC was owned by the state, the government hired an investment bank and asset consultant to guide it through the sale process – the investment bank to secure the best price, and the asset consultant to grade the possible buyer as investment worthy. While State Super was delivering strong investment results on both gross and net basis for our members, for reasons then unknown to me the government put us up for sale.

I remember showing my then CEO at SSIMC a pension finance report demonstrating how internally managed funds can yield huge economies of scale from internalising funds management. Compounded over a few years, these savings were meaningful. We contracted the author of this report to present his findings to the NSW Treasurer with the hopes that it might sway the government to reconsider the sale.

At the end of the author’s presentation, the Treasurer asked one simple question: “Do you insure your own home?”. We were all pretty confused, as the question had nothing to do with the report or the presentation. The author said that yes, he did. The Treasurer said that in his opinion, internally managed funds not only held the principal risk of not delivering the actuarial results required but additionally held the agency risk held by all external managers. If State Super were to suffer a similar fate as Barings, who would underwrite such risk?  His answer was the residents of NSW, wiping out any/all annual savings delivered by internally managed funds. Any such savings, in his opinion, were the cost of self-insuring against such agency risk. I’ll never forget as we all looked at one another, wondering who could counter such a claim. In the end, silence prevailed.

While I philosophically remain an advocate for internally managed funds, I am often astounded as to what little discussion (if any) is given to this agency risk borne by the members of the fund. Does the scrutiny given to the fund’s external managers match the scrutiny given to their own internal investment offerings?

Under defined contribution (DC) pension metrics, the principal risk is borne by the individual superannuant. If the portfolio fails to generate returns commensurate with the actuarial required return the principal risk of underfunding is held by the individual, not the fund. But given that super funds are essentially owned by all the members, agency risk is held by all members, regardless of whether the superannuant is actually exposed to a failed investment trade or not.

If you were to ask a fund manager what keeps them up at night, they’d probably all agree that the risk of “trade fail” is one that could close their doors. Never mind that 99.5 per cent of trade fails are quickly resolved between manager, broker, custodian, and/or administrator. But for the small probability that the provider/fund manager cannot resolve the trade fail, clients are still refunded out of the externally managed firm’s profit pool. For those external managers who are owned via a listed entity, any such short fall could equally come from the manager’s own shareholders equity.

But with a superannuation fund, which might internally manage the assets, where would such a trade fail shortfall come from? There is no profit pool, let alone any shareholders equity. It would have to come from overall assets under management.

While I philosophically remain an advocate for internally managed funds, I am often astounded as to what little discussion (if any) is given to this agency risk borne by the members of the fund. Does the scrutiny given to the fund’s external managers match the scrutiny given to their own internal investment offerings? Is the internally managed team usually overseen by the fund’s own CIO, and if so, isn’t this a conflict of interest? Or is this a potential oversight of the trustee for not creating an independent investment audit function to oversee their internal team with the same rigour as they do to their externally managed funds?

This is where we separate pragmatism from cognitive bias. When I press further and ask trustees how many years of underperformance they would support from an external manager versus the same question for an internal team, the answer is often very different: three to five years for the external team versus five to seven years for the internal team. As a member of the fund, I ask myself why I should care – ultimately, underperformance is still just underperformance. 

Does the internally managed offering have the collective wherewithal and investment infrastructure as that of their external providers, and if not, is this indicative of agency risk that needs their immediate attention? The fiduciary oversight is (and should be) agnostic as to whether or not the team has the same logo on their business cards as the board member. As such, I’d suggest that such an oversight is less an investment issue than a governance issue needing to be addressed. 

  • My Father’s Table is a recurring column penned by Rob Prugue. The previous instalment can be found here.

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