Too many institutional investors are rushing to get into running passive indexed portfolios, when they should be pressing external fund houses to cut fees, says Daniel Gerard of State Street, a big provider of index products. He also pointed to the dilemma such entities face when it comes to insourcing investment management.

Hong Kong-based Gerard, head of advisory solutions for Asia Pacific, consults with various large state funds in the region and said even the biggest investors can struggle with index investment. 

“If we believe that passive investing, or at least some form of systematic strategy, gives us most of what we want,” he said, “then why not try to beat up the providers on price? Why should the provider recognise all the benefits of scale?”

Gerard sees asset owners being challenged to internalise portfolio management and is increasingly sharing the experience of his firm’s larger pension and sovereign investor clients with smaller state and private funds.

Asian institutions are seeking a more sophisticated approach to their portfolio management and risk budgeting, he noted. Part of that process involves a decision on which aspects to manage internally – and it is not an easy dilemma for an investor, whatever their size, argued Gerard.

“The crossover is that Asian institutions want to know how quickly they can move into some of the more difficult-to-understand spaces, like private markets investing, in a measured way that doesn’t expose them to unintended risks,” he noted.

For public-market assets, he said there was a wide variety of opinions on whether funds should internalise investment to save cost. “[Australia’s] Future Fund comes to mind," said Gerard, “where it’s not something that’s high on their agenda because they understand the risk that comes with internalisation.”

In particular, he said asset owners find even passive management challenging and “not synonymous with easy management”.

Harder than expected

One large Asian sovereign wealth fund has commissioned a study of whether it was doing passive index investment correctly, noted Gerard. The institution told him that managing such assets was much harder than they had expected, even with the tremendous resources at their disposal.

The scale of investment can significantly affect the performance of a passive portfolio over time, said Gerard. “Just 10 to 20 basis points difference can have a huge impact on the effectiveness of your programme."

It's hard for an asset owner to evaluate the cost benefits of internalising, he noted, compared to knowing what return they have got for the fees they paid to external managers.

A common complaint from asset owners is that they have spent X million dollars in management fees and are not sure what they got for it, said Gerard. “There’s real money going out and they see how that could have been used to employ people.”

Moreover, once they have settled on an optimal asset allocation, the decision is whether to manage it themselves, he noted.

“When they get to that level of decision-making, it doesn’t have to be across the board. They might want a domestic equity desk, but everything else can be managed outside, and I think what’s what we are going to see.”