Cerulli Global Edge: How Sovereign Wealth Funds Outsource

Cerulli Associates, Global Edge

Key points:

• Sovereign wealth funds have a range of different approaches to external managers.
• Some of the biggest sovereign funds, including ADIA and CIC, outsource the majority of their funds, across all asset classes, and including passive mandates
• Others have all but shut out external managers, tending only to use them in partnership arrangements, usually in alternative asset classes

Sovereign wealth funds show conflicting attitudes to their use of external managers. Some are seeking to bring the simpler, more passive asset management in-house, others to outsource it. Some have abandoned outsourcing completely and prefer to work in partnership with asset managers, particularly in alternatives, while others give a majority of their asset management out to external providers. There is no single established model, and the range of approaches is illuminating, with the lesson for fund managers being: each potential client is very different.

The Korea Investment Corporation, for example, takes what one might consider a logical approach. Although it no longer discloses the proportion of the portfolio it gives out to external managers, it has followed a pattern: start out in any new asset class by seeking external professional assistance, then gradually bring the more passive or benchmark-aware elements of the portfolio in-house as that expertise is developed. That was the pattern in fixed income, then in equities, then alternatives; between 2008 and 2009, for example, as the fund built its internal competence, the proportion of outsourced management fell from 60% to 35% of the fund’s assets, and it is believed to have stayed around that lower level ever since.

This makes a lot of sense, but is not as widespread an approach as one might expect.

The Abu Dhabi Investment Authority, ADIA, is one of the largest and most sophisticated sovereign funds in the world, with ample internal expertise from a staff of more than 1500 people, many of them hired from the highest levels of the private sector. Yet a look at ADIA’s disclosed information on allocations shows that the Korea approach – outsource, get smart, bring the easy stuff back in again – is not the only way to go.

The 2013 annual report, the most recent to be produced, shows that 75% of ADIA’s assets are managed by external fund managers, and that 55% of ADIA’s assets are in index-replicating strategies. The two figures together tell us that much of ADIA’s passive managed is not handled in-house – something ADIA’s staff could very easily do – but outsourced. The logic for this is believed to be that a fund the size of ADIA can negotiate such razor-thin fees for a passive mandate that it simply makes no sense to bother doing it internally. ADIA, incidentally, has by far the highest proportion of funds being managed by external managers of any major sovereign fund that discloses the information, although the figure has come down from 80% in recent years.

Another of the highest public allocations to external managers is in another of the world’s largest funds: the China Investment Corporation. There, 67.2% of assets were externally managed as of December 31 2013, the last disclosed figure.  Compare this, for example, to the end of 2010, when 59% were externally managed; as China has increased its expertise, it has also increased the amount that it outsources.

The opposite of ADIA or CIC is a fund like Singapore’s Temasek or Qatar’s QIA. The Temasek model is different from nearly every other sovereign fund in that it is almost entirely denominated in equities (or in some cases stakes in unlisted companies), and barely any of it requires or involves external fund managers. Temasek may engage investment banks, so as to assist in the purchase of significant stakes, but the only area the institution has been known to use fund managers in recent years has been around hedge funds or private equity. Here, the model looks more like partnership, and this is also increasingly true of the other Singaporean fund, Government Investment Corporation (GIC). GIC does give discretionary mandates to external managers in mainstream asset classes such as global fixed income and global equities – about 20% of its money is outsourced – but is also well-known for having seeded or co-invested in funds with many of the world’s leading experts in private equity, hedge funds and real estate.

At the QIA, although the fund does give some external mandates, the vast majority of the fund’s activities involves direct investments (usually through its Qatar Holdings subsidiary) into major assets, often real estate. Again, the opportunity is chiefly for investment banks rather than fund managers. Where the QIA has been public about its work with external managers, it has been through a partnership model, often requiring the partner to make significant local commitments on the ground in Qatar. Over the years the fund has formed asset management joint ventures with Credit Suisse and Barclays (in both of which cases, incidentally, the QIA holds significant stakes in the parent bank).

In funds that answer to a democracy and a parliament, external management can be politically difficult. Norges Bank Investment Management, for example, which runs Government Pension Fund Global, Norway’s sovereign wealth fund and probably the largest in the world, disclosed that at the end of 2013 it had Kr190 billion, or 3.8% of its capital, under external management, including 50 country-specific mandates for investments in emerging and frontier equity markets, 13 country-specific mandates for small-cap equities in developed markets, five for environmentally related investments, and two for global emerging market debt. Given the scale of the overall fund, the proportion that is externally managed is barely significant, But since Norway’s is perhaps the most transparent fund in the world, the performance of those who act on behalf of it is intensely scrutinised. In February, for example, the fund made a public announcement in response to an article in a Norwegian newspaper that had claimed external managers were not delivering enough risk-adjusted excess return. (The fund said external managers had contributed a positive result of 15 billion NOK after costs since the fund was established.) “We use external managers for most of our investments in emerging markets,” the announcement said. “We also use external managers as a supplement to our internal resources for selected strategies, such as investments in smaller companies and our environmental mandates.”

It tends to be assumed that fees in sovereign wealth mandates are eye-wateringly tight, and in passive or benchmark-close mandates that is generally true. But fund managers do say that in alternative or high-conviction mandates, price is not the key differentiator in winning business, and that in particular when performance fees are built into a fee structure – in hedge funds and private equity in particular – they can be surprisingly generous.

The problem with this diversity of approaches is that it has little obvious lesson for the fund manager. What’s the right approach? Clearly, that depends on the individual fund: where expertise in an alternative asset class and a willingness to partner might be the best way in to GIC, Temasek or the QIA, strength at doing the mainstream things better than anyone else – even the passive – can be a successful way to serve ADIA or the CIC. Successful distribution, in the sense of fund managers seeking sovereign wealth fund mandates, is increasingly a matter of flexibility and understanding exactly the approach of the individual client.