Cerulli Global Edge: Sovereign Funds Polarize on External Managers

Cerulli Associates, Global Edge, November 2015

Sovereign wealth funds are polarizing in their use of external asset managers. While some appear committed to outsourcing the majority of their funds, others are increasingly only interested in managers who either provide a specialist alternative that cannot be replicated internally, or a partnership model that opens the door to new investment possibilities.

Among the big, established heavyweights, ADIA and CIC stand out at one extreme. The China Investment Corporation outsources 67.7% of its assets to external management; at ADIA, the figure is 65%. Since these are two of the largest sovereign funds in the world, this is good news for asset managers.

Both are interesting in their approach. At ADIA, as recently as 2012, fully 80% of its assets were outsourced, much of it in passive allocations (60% of the fund was in passive strategies then, a figure that has since fallen to 55%). This is in itself unusual, as sovereign wealth funds have usually taken the easily-run passive elements of their strategies in-house and used external managers for more specialist, active positions.

While ADIA is clearly bringing more of its assets in-house, under the management of its exceptionally highly-qualified internal teams, it is interesting that it appears to doing so it what might appear an unlikely way. Rather than bringing passive assets under its own supervision, as one might expect, the management that is being brought back in-house appears to be quite technical and specialist. For example, during 2014, ADIA created two new mandates within its Internal Equities Department (that is, funds managed internally): US equities and high conviction. The latter in particular is not normally the sort of mandate that a fund like this would take in-house, not when two thirds of the fund is still outsourced. And two of the three most significant hires over the last two years have been for internal rather than external asset management: Christof Ruhl as global head of research (a role that only really makes sense to support active management) and John Pandtle as head of the US in the internal equities department.  Other areas of increasing internal expertise include real estate and infrastructure.

ADIA’s most recent annual review specifically talks about giving internal managers freer rein, in an open letter from managing director Hamed bin Zayed al Nahyan, who writes of “a new operating model for our investment departments that will increase the flexibility of managers to target alpha opportunities that may not easily be captured within the structure of ADIA’s neutral benchmark, or policy portfolio.” He said the strategy “will empower our skilled investment managers [that is, in-house] to seek outperformance, within agreed limits.”

Where does this leave external managers? For the moment, grateful that 65% of the fund is still outsourced, but also a little uncertain about the future. At ADIA, it appears to be the huge, low-fee passive mandates that are not under threat of being taken away, rather than the specialist active ones, and in that respect, the fund is unusual.

At the CIC, external asset managers are used widely, across the group’s chief investment departments (the Department of Public Equity, the Department of Fixed Income and Absolute Return, and the Department of Private Equity). CIC’s proportion of externally-managed assets has remained consistent for several years and this appears to be a likely long-term position. But it will be interesting to see if the formation of a new subsidiary, CIC Capital, in January, specializing in overseas direct investments, makes a difference to the way external managers are used. A former dedicated department (the Department of Special Investments) was merged into this new vehicle and, since direct investment is generally not done through fund managers but through M&A advisory banks, this may lead to a reduction in the proportion of assets outsourced to third party managers over time.

At the other extreme, several sovereign wealth funds have reduced or streamlined their use of external managers in recent years.

Temasek is at the farthest extreme.  It outsources about 10% of its portfolio, and even that is inaccessible to most mainstream fund managers.

According to briefings from Temasek insiders, that 10% is held in third party funds for particular reasons: exposure to new geographies, markets or asset classes where the fund has no depth of expertise. So, for example, when Temasek set up in Brazil and Mexico over the last few years, it did so initially with no experience in those markets at all, and so did almost everything through investment in third party funds at first.

Additionally, Temasek prefers the co-investment model. So, instead of undertaking specialist venture capital itself, it might co-invest with a venture capital fund which helps to provide access to interesting deals at an early stage that either would not have been possible for Temasek otherwise, or that it simply would not have known about.

This co-investment model is increasingly widely practised. At neighbouring GIC, also in Singapore, building in-house capability has been a point of pride ever since the fund’s foundation in 1981. While external managers are still used, they are very much a minority, and thought to account for 20% of assets.

GIC says it invests directly in a variety of funds, including real estate, private equity, bond, index and hedge funds, as well as giving discretionary mandates in global fixed income and global equities. But it is believed that external managers are used particularly widely in alternatives. GIC is believed to have invested in or alongside pretty much every major name in global private equity over the years.

Although it no longer produces this chart in its annual reviews, in the 2011-12 report GIC included an essay explaining its use of external managers, and disclosed that 54% of its external mandates were in what it called ‘marketable alternatives’, compared to only 36% for equities and 10% for fixed income and FX. (It also disclosed that 58% of external managers were in North America, and a further 22% in Europe).

This confirms what asset managers have been saying about GIC, and Singapore’s sovereign funds generally, for some time: that if you want a mandate, it’s best to be in an alternative asset class with a niche proposition that GIC’s enormously sophisticated in-house team can’t already reach.

An example of a common pattern – using external managers early on, then bringing the expertise in-house as that team gains sophistication – is illustrated by the Korea Investment Corporation, which now manages 73.2% of its funds internally, compared to just 40% in 2008.

They, too, tend to gave mandates to asset managers who can offer something different: alpha, and often in a non-mainstream asset class. In its early days, KIC was chiefly in fixed income, and outsourced most of that. Then, as it staffed up, it brought the more straightforward fixed income management in-house. It launched in equities, again outsourcing most of the funds; then, as it built internal expertise, it brought much of the money back in-house again. Today, it’s not likely to increase the proportion managed internally much further, but those who want mandates will have to be offering something that KIC hasn’t already developed the skills to do itself.

Another clear illustration of this approach can be found in Norway, with Government Pension Fund Global, the sovereign fund run by Norges Bank Investment Management. At the end of 2014 NBIM had 80 mandates to external managers, worth NKr276 billion, which sounds a lot (and is a lot) but actually represents only 5% of the fund’s total assets. It’s worth taking a closer look at the underlying names for those mandates. While the externals in fixed interest are big names like Ashmore and Templeton, many of the almost 70 fund managers known to hold equity mandates are far less well known: Abax Investments, Avaron Asset Management, Keel Capital, Karma Capital Advisors.

NBIM says it uses external managers mainly to enter markets, often countries, that are costly and unrealistic for it to build up in-house expertise to manage. For a conservatively managed fund, it is very diverse, including some frontier markets: at the end of 2014 it was in investments related to 75 countries and 47 countries, including 18 normally classed as frontier and a further six not even within FTSE frontier indices, such as Panama and Kazakhstan. It holds, for example, 20 companies in Vietnam and 11 in Kenya. This is the sort of area where fund managers can hope to gain an NBIM mandate.

If managers are not specialised or alternative enough to win these mandates, what then? Another approach is to look to the many new sovereign wealth funds that are starting out, and that are going to need help in the early stages, even in mainstream asset classes and geographies.

An example here is Nigeria, which is in the early stages of a complex three-fund approach to sovereign wealth: a stabilization fund, an infrastructure fund, and a future generation fund (the part that looks like a classic sovereign fund). Forty per cent of oil surpluses should go into this latter fund, with a target allocation of 80% for growth assets; it is likely that much of that will need the assistance of external managers.

One could as easily look at funds from Angola to Kazakhstan, Mongolia to East Timor or Papua New Guinea. An increasing number of resource-rich countries feel they need a sovereign fund in order to diversify assets for the long term. Clearly, Ulaan Baatar, Dili and Luanda are not as rich in investment expertise as they are in hydrocarbons, so these funds – some of which may grow to have tens of billions of dollars under management – will be lucrative sources of outsourcing mandates in their early years.