Sovereign Wealth Funds Look for Inside Edge by Managing Money In-House

WHAT A DIFFERENCE half a decade makes. When Dong-ik (Don) Lee joined Korea Investment Corp. in December 2008 as head of its new alternative-investment team, the sovereign wealth fund was struggling to diversify its then-$17.8 billion portfolio and shore up its assets. Morale was low, and losses were mounting. Eleven months earlier KIC had made an ill-timed $2 billion investment in Merrill Lynch & Co., and the troubled investment bank’s share price was in free fall. Most of KIC’s portfolio was being managed externally, but the fund had begun hiring more internal portfolio managers to run a wider range of fixed-income and equity strategies in-house to save money and capitalize on economies of scale.

Fast-forward five years, and KIC has undergone a dramatic transformation, building up its asset management staff, diversifying its portfolio and reaping the cost benefits of running more of its own resources. The fund’s portfolio was worth $56.6 billion at the start of this year thanks to healthy returns and fresh capital infusions from the South Korean government, pushing it up to No. 17 in Institutional Investor’s 2013 ranking of the world’s largest sovereign wealth funds. Under the guidance of former CIO Scott Kalb, a hedge fund and financial markets expert who took charge of the fund in 2009, KIC separated its pure market-beta strategies in stocks and bonds from those powered by manager skill, or alpha; moved the former in-house; and added a sweeping alternatives allocation. By repositioning its investment team to oversee passive and enhanced-beta strategies internally, KIC reduced the fees it paid to external asset managers, allowing the organization to spend more of its risk budget on alpha generation.

The World’s Biggest Sovereign Wealth Funds

Having worked closely with Kalb, Lee is now building out KIC’s internal asset management expertise to complement its alpha-seeking initiatives. Over the past year the sensible, good-natured private markets specialist — whom KIC staff wryly nicknamed the Enforcer — has worked to further diversify the fund’s external mandates and expand KIC’s internal talent pool. At the end of 2008, 35 percent of the fund’s stock and bond investments were being managed internally and the remaining 65 percent were managed externally. Today those percentages have flipped.

“Our job is to manage more actively,” says Lee, 55, who stepped into the role of CIO in April 2012 after Kalb’s government-mandated three-year term ended. “Of course, our sponsors have given us some guidelines about how we do that, but we want to hire good traders and build our own expertise.” His efforts don’t preclude using external managers for niche strategies, he adds, “but you don’t want to have too many.”

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KIC is not alone in seeking to gain greater control of its own destiny. In the five years since the global financial crisis ripped holes in the balance sheets of some of the world’s most sophisticated investors, many of the largest sovereign wealth funds have become increasingly self-reliant, including the Abu Dhabi Investment Authority (ADIA), Norway’s Government Pension Fund Global and Singapore’s GIC. Frustrated by the rich fees, disappointing returns and misaligned incentives of some of their external asset managers revealed by the global financial crisis, sovereign wealth funds are seeking to recalibrate the balance of power. The results are striking. According to Institutional Investor’s Sovereign Wealth Center, the ten largest sovereign wealth funds now run an average of 62 percent of their assets in-house and outsource just 38 percent.

The age and size of a sovereign wealth fund usually correlate strongly with its ability to run diverse strategies in-house, but newer funds are gaining ground. KIC, which handles index-replication strategies in-house, has also taken greater control of enhanced beta and active strategies in highly liquid asset classes like fixed income and equities, freeing up its team to allocate more risk to external alternative investments. Older, more established funds like ADIA, having already mastered investing in listed securities, have sought to achieve better deal terms and alignment of interests by insourcing some fee-rich alternative-investment strategies, particularly in private equity and infrastructure. In aggregate, their efforts are transforming the relationships between sovereign wealth funds and their asset managers, which have had to rethink their incentives, dilute their fees and provide unprecedented access to their own trading and investment teams. (Read more: “Sovereign Wealth Funds Put the Pressure on Private Equity”)

“Expectations of alpha have risen,” says Gavin Ralston, head of official institutions at London-based asset management firm Schroders. “If a sovereign wealth fund is going to externalize a mandate, the hurdle of what its own internal team can achieve sets the benchmark, so there is constant pressure to deliver more.”

The power of insourcing to match — or even outperform — private sector asset management has long been recognized within the sovereign wealth and pension fund communities, but doing it well isn’t easy. Running money in-house requires strong political institutions, a supportive governance structure and an expert board of trustees that is willing to provide a given fund with adequate resources. Even armed with those tools, sovereign wealth funds have to be prepared to fight for talent in a competitive marketplace, embrace end-to-end risk management in the investing process and assume responsibility for their own returns. It’s a tall order. But by bringing asset management in-house, a range of institutions are becoming stronger, more efficient fiduciaries.

“Many sovereign wealth funds really like to have a long-term investment horizon, which may extend as far out as ten to 20 years — or even beyond,” says Jukka Pihlman, Singapore-based global head, central banks and sovereign wealth funds, for Standard Chartered. “A private equity or infrastructure fund will typically only invest for a period of five to seven years, and that difference can be a source of frustration.”

The champions of outsourcing are vocal about its challenges and its potential rewards. Leo de Bever, CEO of Alberta Investment Management Corp. (AIMCo) — which manages approximately C$70 billion ($67.7 billion) for 27 pension, endowment and government funds in Alberta, Canada (including the Alberta Heritage Savings Trust Fund, a sovereign wealth fund with $16.5 billion in assets as of December 31, 2012) — believes that political independence is the single most important structural element determining the success or failure of a fund’s insourcing efforts. Without sufficient autonomy, he says, a sovereign wealth fund may suffer from an overabundance of caution irrespective of its age, assets under management or track record.

“Within governments the culture is all about ‘see risk, kill risk,’” says de Bever, a veteran of the Ontario Teachers’ Pension Plan (OTPP) who joined AIMCo in August 2008. Since taking the helm de Bever has transformed AIMCo from an investment firm that largely outsourced asset management to one that now runs 85 percent of its assets internally, across a diverse array of long-only and hedged investment strategies. Although AIMCo lost money during the crisis, it delivered a net return of 11.9 percent for its pension and endowment fund clients in 2012. “With investments you have to be able to take risk to make money, which is a very different philosophy,” de Bever adds. “Here at AIMCo it took us a couple of years to get it right.”

For sovereign wealth funds with ample institutional safeguards, getting it right can potentially save hundreds of millions of dollars in fees. Although pooled data for sovereign wealth funds is difficult to obtain, Toronto-based global pension research company CEM Benchmarking has gathered information on the average cost of internal and external investment management services for 301 institutions — mainly pension funds but also some sovereign funds — that collectively invest $5.58 trillion globally. According to CEM’s most recent analysis, which captured fee data as of December 31, 2012, the more exotic the strategy, the greater the potential fee savings (see chart). The median cost of a fund running its own diversified private equity portfolio, for example, was 30 basis points, far less than the 165 basis points for using an external manager.

Source: CEM Benchmarking.

1 Cost as a percentage of fees in basis points. 2 Costs include internal oversight on externally managed assets.

“The biggest bang for the buck seems to be in asset classes where fees are traditionally high,” says Ashby Monk, executive director of Stanford University’s Global Projects Center, an interdisciplinary research group that focuses on finance, governance and management issues faced by pension and sovereign wealth funds. “If you’re going to insource asset management, of course you can do it in passive strategies, but how much will you really be saving? Five or 6 basis points? But, my goodness, in private equity, infrastructure and perhaps even in some hedging strategies, the potential to save money is vast.” (Get more from Ashby Monk.)

In the global pension fund community, the Canadians are renowned for their ability to insource. De Bever has been a key architect of that process since he joined OTPP in 1995 as its head of research and economics. A seasoned quant, de Bever transformed OTPP’s risk management from a control system into a methodology for evaluating investment alternatives across the portfolio; his innovative risk budgeting approach ultimately freed his colleagues at OTPP to make original choices about asset allocation and diversify more fully. Although de Bever left OTPP in 2004, his legacy continues. OTPP, which is now led by CEO Jim Leech and CIO Neil Petroff, is well known for its insourcing prowess and makes direct investments in companies and real assets. Since 1990, when OTPP’s diversified investment program began, the pension fund has earned a 10.1 percent average annual return.

Halfway around the world the Singaporeans have gained similar recognition for their ability to innovate — and internalize asset management — at their sovereign wealth funds GIC and Temasek Holdings. Founded in 1981 with $5 billion in excess foreign exchange reserves from the Monetary Authority of Singapore, GIC launched with “the aspiration to build an internal capability so as to control our own destiny,” says Lim Chow Kiat, GIC’s group CIO, who answered questions about the fund’s insourcing strategy by e-mail.

In the early days GIC, which ranks No. 6 by assets under management, spurred its teams to excel by comparing investment performance, net of costs, across internal and external mandates and allocating capital accordingly, Lim says. By working closely with external managers and absorbing their investment discipline, the sovereign wealth fund moved inexorably up the risk curve from marketable securities to direct investments. GIC’s team now has the skill to invest across a full spectrum of financial assets, from sovereign debt to infrastructure, and manages approximately 80 percent of its estimated $279 billion portfolio in-house. Although GIC could easily run all of its assets internally, the organization has chosen instead to continue to work with external managers because they can provide valuable insight into global markets and access to niche strategies, the CIO says.

“We will always have external managers,” says Lim, 43, whose career exemplifies GIC’s ability to recruit and train investing talent. The Singaporean executive, who joined GIC in 1993 as a freshly minted graduate of Nanyang Technological University, has spent his entire career with the sovereign wealth fund, serving in a variety of investment roles in Asia and Europe. In January 2013 he was named group CIO.

Although GIC still uses external asset managers to run up to 20 percent of its assets, the fund’s style of engagement has shifted subtly since the financial crisis. Although the composition of its portfolio has held fairly steady since 2007, GIC has been streamlining its allocations to private equity funds and replacing those stakes with direct investments or co-investments. In Brazil, GIC was part of a consortium that acquired 18 percent of leading local investment bank BTG Pactual in 2010 through a direct investment; the other members of the consortium included Abu Dhabi Investment Council, China Investment Corp. (CIC), OTPP and U.S. private equity firm J.C. Flowers & Co.

Sourcing deals, however, takes time, effort and expertise, especially in emerging markets, which Lim discussed in an exclusive interview with Institutional Investor’s Sovereign Wealth Center. In the five-year period ended March 31, 2013, GIC nearly doubled its exposure to emerging markets, from 14 percent of the portfolio to 27 percent, and opened investment offices in China and India. (The fund plans to open an office in Brazil in 2014.) GIC also encourages corporate networking closer to home: This month the fund is cohosting a forum, the Singapore Summit, in cooperation with the Singapore Economic Development Board, the Monetary Authority and Temasek. The event, which is expected to attract some 300 senior executives from companies based in 25 countries, will allow participants to discuss the axis of mutual influence between Asia and global emerging markets.

Although GIC may have had an early start in developing its own internal investment expertise, its peers in the sovereign wealth fund community are catching up quickly, hiring staff to help diversify their holdings and produce increased efficiencies of scale. Norway’s Norges Bank Investment Management (NBIM), the arm of the central bank that oversees the Government Pension Fund Global — the world’s largest sovereign wealth fund, with $685.8 billion in assets under management as of December 31, 2012 — has dramatically cut its use of third-party investment managers. Last year NBIM invested only 3.8 percent of the fund with external managers, down from 13.2 percent in 2008.

The challenge of developing internal capability is arguably far simpler for NBIM than it is for GIC because the investment team largely allocates the giant Norwegian fund to passively managed, index-tracking investments in stocks and bonds. NBIM gained the freedom to invest in real estate only in 2010, and since then the team has been chasing a 5 percent allocation to the asset class. Although NBIM’s CEO, Yngve Slyngstad, declined to comment on his team’s insourcing capabilities, NBIM has said it now uses external managers largely to gain exposure to geographic areas, market segments and industrial sectors in which it lacks expertise.

Other large sovereign wealth funds have reduced their dependence on external asset managers since the financial crisis. ADIA, which ranks No. 3 on our list, with an estimated $405 billion under management, is becoming more resourceful at running its own money. In its 2012 annual review, ADIA revealed that it has been hiring senior investment professionals with experience in hedge funds, commodities trading advisors and private equity, having previously bolstered its real estate and infrastructure teams. Consequently, ADIA’s dependence on market-mirroring passive strategies fell slightly as the massive fund took advantage of relative-value opportunities in private markets during the year. The shift may reflect an allocation bias rather than a deliberate redistribution, but it had a noticeable effect. In 2012, ADIA’s exposure to index-replicating strategies fell from 60 percent to 55 percent, and the percentage of assets managed externally declined from 80 percent to 75 percent.

Smaller sovereign wealth funds are also seeking to become more efficient in their use of external asset managers. The New Zealand Superannuation Fund (NZSF), which oversees $17.3 billion in extrabudgetary assets, has blazed a bright, profitable trail in the wake of the global financial crisis by insourcing more of its asset management and developing the capability to shift its risk exposures at will, depending on various market signals, without disrupting its core long-term strategy.

NZSF’s reference portfolio, which is entirely passive and uses only listed securities, is split between an 80 percent allocation to growth assets (global equities, New Zealand–listed equities and global listed property) and a 20 percent allocation to fixed income. As part of the reference portfolio approach, NZSF seeks to capture returns above those generated by the reference portfolio through unusual active investments across a wide variety of assets (including private equity, infrastructure, timber, farmland and even insurance-based products) and its unique style of dynamic asset allocation, which allows the team to tilt the balance of the portfolio for months — or even years — when it believes an asset class is mispriced. The results have been impressive: In the trailing 12 months through June 30, NZSF delivered a net return of 25.8 percent; since its inception in September 2003, the fund has an annualized return of 8.8 percent.

Adrian Orr, NZSF’s outspoken and energetic CEO, is hard-pressed, however, to pinpoint how much of the fund’s money is run internally, because all of its investment decisions are made in-house. In capital terms, he says, about one third of NZSF’s net asset value is actively managed by external managers. But viewing the portfolio through a risk budget framework, by far the bulk of the active risk is managed internally — either through selection of the reference portfolio, which is passive, or by a combination of strategic tilting and opportunistic direct investments in various assets, including infrastructure, timber and New Zealand farmland. Although NZSF’s approach wasn’t dictated by a desire to save money on fees, it is proving cost-effective. “We are starting to see the early days of quite significant economies of scale,” Orr says. “As our assets under management have grown, the fee structure for running the whole portfolio has been coming down, which is great.”

Not all sovereign wealth funds are able to insource as effectively and efficiently as they might like, even if they have the structural freedom to do so. In 2012, CIC, No. 2 in our ranking, with $575.2 billion under management (of which $190.2 billion is invested overseas), reported that it had increased its use of external managers from 57 percent of assets under management to 64 percent for its foreign investments. This change represented $38 billion worth of new mandates in 2012. Striking as that adjustment appears, CIC’s reasons for outsourcing may be more pragmatic than philosophical. Since its inception in 2007, the fund has aspired to develop its in-house asset management capabilities in the style of Singapore’s GIC, but in the first six months of 2012, CIC lost eight senior employees, mostly from its private equity and real estate divisions.

As ubiquitous as insourcing has become among some of the largest sovereign wealth funds, it is not the only way to diversify investment management. Australia’s Future Fund, which ranks No. 12, with $85.6 billion under management, has chosen to prioritize total portfolio strategy over in-house investment management. The approach makes perfect sense in the context of the Future Fund’s founding legislation, which essentially requires the organization to outsource investment activities to external managers, presumably to mitigate possible conflicts of interest and reduce the likelihood of direct competition. Although CIO David Neal and his team can make direct investments, they can do so only by using financial instruments; they cannot own nonfinancial assets, like buildings or toll roads, outright.

“We have had a very strong view that substantial value comes from focusing on the strategic settings of the total portfolio,” Neal explains. “I don’t just mean setting a strategic asset allocation; I mean understanding the nature of the portfolio we’ve got and the opportunity sets before us.”

In response to the Future Fund’s legislative parameters, Neal has encouraged a close, collaborative style of engagement with the fund’s external managers. He and his team frequently leverage their connections to explore co-investment opportunities in private equity, real estate and infrastructure. Although Neal emphasizes strategic portfolio allocation as the fund’s first priority, he seeks out seasoned investment practitioners who can bring their skills to the discussion. All of the Future Fund’s sector heads in private equity, infrastructure and property have had experience conducting direct transactions. The difference: At the Future Fund, Neal challenges his sector heads to think about the balance of opportunities for the fund as a whole, across all asset classes, not just their particular areas of expertise. From his perspective the best way for the fund to achieve its goals is to gather a small group of experts around a single table. “The danger for us is that if we added more people, it would just dilute our focus,” Neal says. “We don’t want to undermine our investing culture.”

Inevitably, the gradual shift toward greater internalization of asset management has transformed the way sovereign wealth funds engage with their external investment firms. Not only do outside asset managers have to generate better returns than a given fund could achieve in-house with its own team, they are also called upon to provide insight, information and even training for their clients’ internal investment staffs. The process of knowledge transfer, as it is known in the trade, has become an indistinguishable part of managing sovereign fund assets.

“We frequently offer training as part of our management contract,” says Schroders’ Ralston. “Usually, it’s more relevant to central banks than to sovereign wealth funds, but as more funds run assets internally, the training is becoming a bigger part of what we can provide.” Often, the newer the fund, the more help and engagement are required. Although the Future Fund diversified remarkably quickly given the experience and focus of its management team, the majority of recently formed sovereign wealth funds move very cautiously into new asset classes, preferring to familiarize themselves with core allocations like fixed income and listed equities before venturing into more-exotic securities and strategies. Getting the right people in place takes time, especially because many sovereign wealth funds are now competing for talent directly with the private sector. Over the past two years, KIC, for example, has been on a hiring spree. Since 2011 the fund has added ten to 20 new employees each year, taking the total head count to 150, nearly half of whom are investment professionals. “We would love to hire more talented people,” Lee says. The CIO and his team are particularly keen to find recruits with experience in private equity. Even as he brings in new hires, however, Lee will continue to use external managers. “I think there is a value in using external managers, especially if we are hiring them in more-niche markets, smaller markets,” he says. “Those kinds of investments are hard to attack by ourselves.”

With help from its external managers, KIC was able to accelerate its portfolio diversification drive after the financial crisis, mitigating its exposure to stocks and bonds. In 2009 the fund launched its private equity program; the next year it began investing in hedge funds and real estate. So far, those forays have proven beneficial — and profitable. At some point in the future, KIC may begin to insource more, particularly in deal-oriented strategies like private equity and real estate, but for now the fund is still adding external mandates. Just last month Lee confirmed that KIC is looking to spend as much as $10 billion on alternatives, tripling the fund’s current allocation, on the assumption that the fund’s total assets under management will also grow significantly.

Hedge funds have not been subject to the same degree of pressure that sovereign wealth funds have been applying to private equity firms, perhaps because their strategies are so diverse and in some instances harder to replicate. Some sovereign wealth funds do run dedicated hedge fund teams, but staffing them with talented traders isn’t easy. Compensation is a real challenge. A few organizations, like AIMCo, have persevered nonetheless and developed their own internal expertise. AIMCo’s de Bever says his organization has sought to insource some of its quantitative hedge fund strategies as a means of cutting costs. The Future Fund’s Neal takes a slightly unusual view of the hedge fund industry in that his team focuses primarily on just a few types of strategies, including global macro, commodities and credit. Although the Future Fund does have a long-short equity strategy, it is overseen by external managers as part of the fund’s global equity allocation.

Sovereign wealth funds appear far more inclined to engage in deal-making activities, regardless of asset type, than they are to develop complex hedging strategies in-house. But they have the capability of directing resources wherever they see fit. Looking ahead, co-investments in private companies will probably rise as sovereign wealth funds become more confident in their own abilities to judge the merits of individual deals. A handful of sovereign wealth and pension funds are even seeking out their peers and forming consortia to acquire assets. Occasionally, surprising new alignments appear. In October 2012, GIC and the Hong Kong Monetary Authority teamed up to buy a 92 percent stake in a building — 101 California Street in San Francisco — for which they paid $860 million. That same month news broke that Bank of China, KIC, NZSF and Temasek had invested in an infrastructure fund sponsored by BOC International Holdings, a division of Bank of China.

“The co-investment model has really gained popularity in the sovereign wealth fund community, because it is kind of direct but not entirely so,” says Standard Chartered’s Pihlman. “You’re doing it with a partner who also has their own skin in the game, so the alignment of incentives is better.”Sovereign wealth funds are unmistakably starting to transform deal structures in private markets, but their future impact on other types of investment strategies is harder to gauge. Without question, however, they are challenging their alternative-asset managers to deliver better value and more-innovative ideas, even if those ideas do not come packaged in ready-made funds. The irony for asset managers is that if they do their jobs well as educators, they may render their own services obsolete. Former clients may become fierce competitors, as well as future collaborators, once they learn how to wield the tools of the trade. • •