The discussion was sponsored by Stikeman Elliott and moderated by Jim Leech, Chair, Advisory Board, Institute for Sustainable Finance, and former CEO of Ontario Teachers' Pension Plan.
You can view the discussion here (on the replay, fast forward to minute 56 to view) or watch it on YouTube below and here.
Before giving you my thoughts on the discussion, I refer you to the latest CEM Benchmarking research paper, A Case for Scale: How the world’s largest institutional investors leverage scale to deliver real outperformance, which you can download here.
The paper was co-authored by Alexander D. Beath, Rashay Jethalal, and Michael Reid.
Below, you can read the executive summary:
Many large institutional investors hold the belief that they have an advantage over smaller investors on account of their scale. How does that scale equate to an advantage, and does scale really result in better returns? Analysis of CEM Benchmarking’s database of large asset owner cost and performance data shows that the largest institutional investors do add incremental value over and above smaller funds. In particular:
- Institutional investors have, on average, been able to deliver returns that exceed fund benchmarks gross of costs. Net of costs, funds with more than $10B (USD) in assets under management have consistently delivered excess returns that are significantly higher than smaller funds with under $1B (USD) in assets under management.
- These large funds have been able to achieve these positive results while taking on less active risk than smaller funds.
- The advantages of scale most prominently manifest themselves in the ability to implement private assets internally, resulting in much lower overall private asset management costs.
- Net of costs, the largest institutional investors deliver more value added than smaller funds in both public and private markets, an advantage driven almost entirely by lower staffing per dollar invested and lower fees paid to external managers
I recommend you read the entire paper but let me bring your attention the beginning where they examine how much value do institutional investors really add:
To assess the success of a fund we will focus on value added, the difference between a fund’s policy benchmark and the actual return realized by the fund. Value added is the sum of both manager value added within asset classes and tactical portfolio decisions between asset classes. Value added has the advantage of being relatively agnostic to asset mix, enabling comparisons across funds.
Analysing nearly 9,000 observations from 1992-2020, we find the average fund in the CEM database has outperformed their benchmark by 67 basis points (bps) gross of costs and 15 bps net of costs [exhibit 1]. It is reassuring to note that the evidence shows that large institutional investors are able to add value over long periods, even if more than 75% of the gross value added generated is eroded through costs.
Breaking down these results by assets under management (AUM) begins to reveal the outperformance delivered by larger funds. Smaller funds with under $1B AUM delivered 47bps of outperformance before costs, 36bps lower than the 83bps of outperformance delivered by funds with more than $10B AUM. In fact, after accounting for cost, funds under $1B failed to deliver any value on average whereas the larger funds averaged 29bps in annual excess returns.
One possible explanation is that the largest funds are simply taking on more active risk than smaller funds. By looking at the observed range of value added, we can confidently say that this is not the case; the standard deviation of value added for the largest funds (190bps) is 33% lower than that of the smallest funds (291bps). Not only are larger funds generating higher value add, but they appear to be doing so while taking a lower level of active risk (or as likely, diversifying away more of their active risk).
This observation is especially important when one considers the almost complete lack of persistence observed in value add. Put another way, much of the variability in value added can be attributed to randomness rather than skill.As stated previously, we observed that the average fund (irrespective of size) generated an average annual net value added of 15bps. The standard deviation of this net value added is 242bps. What that means is that in any given year, roughly 2/3rds of observed net value added will be between -227bps and 257bps. This is quite a wide range and raises the question: is it possible to realistically aim to be at the top of this range every year?
We can assess how much of the difference in net value added is due to differences in skill by comparing the range of 1-year value added to range of multi-year value added. If success and failure in generating above average value added is random, then the distribution of the value added should shrink over time, as “lucky” up years cancel out “unlucky” down years.
Indeed, while the 1-year standard deviation of value added is about 240 bps, the 4-year standard deviation of value added is half that, around 120 bps, and the 20-year value lower still at 54 bps. Not only does the standard deviation decline, but it does so almost precisely in the pattern that would be expected if value added from one year to the next were random. In other words, most of the variability in 1-year value added is not difference in skill, but instead difference in luck.
What this suggests is that it is not reasonable to expect recent outperformance (or underperformance) relative to similar peers to persist. It also points to the fact that the lower level of active risk taken by larger funds is likely to be accretive to overall returns over the long term. The largest funds have delivered better outcomes over longer periods both before and after costs – and they have done so while taking less active risk. Are there any additional empirical insights that we can make to further the case for scale?
Here is the critical part: "It also points to the fact that the lower level of active risk taken by larger funds is likely to be accretive to overall returns over the long term. The largest funds have delivered better outcomes over longer periods both before and after costs – and they have done so while taking less active risk."
Now, none of this surprises me, the larger funds have comparative advantages smaller funds simply don't have:
- Better compensation to attract top talent and manage more assets internally across public and private markets.
- More assets under management allowing them to partner with top partners all over the world and negotiate lower fees and co-investments on larger transactions, lowering fee drag.
- Bigger balance sheets allowing them to leverage these balance sheets intelligently to increase diversification and lower risk (see my recent comment where CPP Investments' CIO, Ed Cass, discusses leverage to CalPERS' board of directors).
- The ability to do highly sophisticated credit deals that smaller funds simply cannot do (see my recent discussion with Andrew Edgell, Senior Managing Director & Global Head of Credit Investments, at CPP Investments).
- A total fund management approach that manages liquidity and risk very closely and focuses on capitalizing on where the best opportunities reside across assets.
- Last but not least, better governance allowing them to operate like large businesses, independent from governments.
I'm not going to lie, there are many good and even great smaller funds but if it were up to me, I would definitely consolidate many of the smaller pensions into the larger ones.
For me, it's all about achieving better outcomes, and to achieve the best outcomes, you need scale.
Again, scale isn't the only thing you need but without scale, you're limited in what you can achieve.
Over the long run, the results speak for themselves, larger funds add significant value added at lower levels of active risk.
Anyway the discussion between Bert Clark, Rashay Jethalal and Jim Leech was excellent.
Bert made a good point off the top on the report, stating while "there's an obsession with manager value added", the truth is what's really important is "getting your asset mix right, making sure you're managing your liabilities, making sure you're managing your liquidity well."
He talked about the "free lunch of diversification" and getting your costs down to "improve net performance without taking on more risk."
He stated "a lot of the risk-free return strategies are only available to big investors so sadly smaller investors have to increase risk to deliver the same returns."
Again, think of what one expert recently told me about balance sheet management: "You can easily add 50 basis points of value add without taking on more risk just by optimizing your balance sheet management."
Smaller funds simply can't do this for a whole host of reasons.
Bert said there are 80 smaller funds in Ontario that are managed "sub-scale" and here he wasn't targeting them, just stating a fact, many of these funds weren't set up properly from the get-go and IMCO is set up properly and has the requisite scale/ governance to easily grow its assets under management.
He said that IMCO was set up in 2016 and even though public sector organizations don't move quickly, IMCO is starting to get more assets from new clients (city of Ottawa pension, Ontario judges, and more to come).
It's important to note unlike its peers, IMCO doesn't have "captive clients", they are voluntary clients" who can leave if they're not happy with the way their pension assets are being managed.
Bert also made the important point that it's not easy to access top private market investors and the fees you pay might eat away all the returns over time.
So IMCO identifies the best investors in each asset class and selectively invests with them and co-invests alongside them to lower fee drag.
That, in a nutshell, explains a lot of the success of the Canadian model.
And Jim Leech made a good point, you still need a good internal team to co-invest on larger transactions to avoid adverse outcomes.
Rashay Jethalal confirmed that many of the smaller funds give away their private market returns in fees. He offers many great insight sin this discussion.
Importantly, he states: "The data doesn't support diminishing returns as the funds get larger."
Jim Leech noted the Americans have many large funds but they never appeared among the global top performers. The main reason why is they lack the governance Canadian funds have.
Lastly, Bert Clark mentioned that larger funds are able to capitalize on the biggest and best opportunities in the energy transition market, citing their investment in Green Frog Power.
Rashay confirmed ESG through scale matters and produces significant added value.
Anyway, take the time to listen to this discussion below, it's excellent and covers a lot of ground.