Asian institutional investors need to outsource more to external managers as they’re raising their risk exposure and diversifying portfolios far faster than global peers, says Greenwich Associates.

The US-based research house warns that increasing complexity and changing risk profiles of institutional portfolios will represent a real challenge to Asian asset owners.

Fixed income investments made up an average 73% of Asian institutional portfolios in 2010, but by 2012 that figure had dropped to 58%. Meanwhile, equity allocations increased from 13% to 26% over the same period, in contrast to the de-risking trend in the US and Europe.

Between 2010 and 2012 Asian institutions’ average allocations to domestic equities increased from 5% of total assets to 10%, while to international equities it grew from 8% of assets to 16%.

But the move out of cash and domestic fixed income and into higher volatility asset classes is not restricted to equities, but also emerging markets, specialised fixed income and alternatives.

“Any institution that is attempting to actively manage its own assets for the purpose of generating alpha is competing directly with asset management companies that are more focused on investing, usually better equipped and typically staffed with investment professionals who are better paid and therefore often more experienced,” says Greenwich consultant Markus Ohlig.

“For that reason, as Asian institutions diversify their portfolios, they should consider following the example of their counterparts in Europe and North America by leaning more heavily on the support and expertise of external asset managers and consultants.”

Greenwich notes that although the share in assets managed internally by Asian institutions has been declining for the past two years, they still handle an average of 80% of exposures in-house. For smaller institutions, the mean figure stands at 94%, with no shift to external management.

Again this contrasts sharply to the US and Europe. Overall, US institutions manage just 12% of their assets internally, and this is limited almost exclusively to the largest organisations.

In continental Europe, where insurance companies make up the biggest part of the marketplace, institutions managed 51% of assets internally on average in 2011 – a decline from 70% in 2010.

Abhi Shroff, principal at Greenwich Associates in Singapore, notes that one of the reasons internal management is far lower in the US, Japan and the UK is that the institutional market there is mostly made up of pension funds, which have fiduciary responsibility to use external managers.

“If you are an accountant managing a pension fund, you want to hire outside help so you are not held accountable for investing people’s money,” he says.

The shift by Asian institutions to internalise management in particular gathered speed after the financial crisis, when in-house managers handling domestic investments outperformed external parties with global mandates.

“It was the wrong lesson to take away, that internal managers perform better, but that is the lesson that many institutions did take away and many started to put more resources into internal teams,” adds Shroff.

“But when you start to look at more complex strategies such as international equities, specific fixed income and alternatives, this becomes harder and harder for internal teams to manage.”

The point is that investment management firms can pay portfolio managers, analysts and traders salaries that are out of the reach of most institutional investors, notes Shroff.

Importantly, asset management firms offer enticements in the form of performance-based bonuses that can’t be matched by the vast majority of buy-side institutions. In other words, institutional investors are in general unable to attract the same level of talent.

On the question of fees, Shroff concedes that there is a strong incentive for institutional investors to insource management, but adds: “You can do it more cheaply, but can you do it as effectively?”

At the same time he notes that fees charged by external asset managers are generally lower in Asia than in North America, Europe and Japan, which over the longer term is affecting how these managers are staffing their operations to service clients in the region.

Because so many assets are managed internally in Asia, mandates for external managers are usually small relative to other markets, so the combination of small mandates and low fees limit the attractiveness of this business for managers.

The reality is that outside of a few locations such as Singapore and Hong Kong, where competition is intense, asset management firms’ country operations are staffed thinly.

“These staffing levels help to explain why the service quality Asian institutions receive from external asset managers falls short of that received by institutions in other markets,” says Shroff.