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Internal Management Performed Better

By: Hubert Lum

Contrary to popular perception, funds with more internal management performed better than funds with less during the 13-year period ended December 2004. On average, funds earned 0.55 basis points more total fund net value added for every incremental per cent of internal management. Canadian funds with internal management performed even better. They earned 0.80 basis points more total fund net value added for every incremental percentage point of internal management.

These findings were significant at the 99 per cent level. The t-value for the co-efficient for internal management for all funds was 3.2. The findings were based on a regression of net value added against the per cent of internal management. Net value added equals total return minus policy return and costs. Policy return is the return that could have been earned passively by indexing a fundʼs investment policy asset mix. The regression used 3,513 annual observations from CEM Benchmarkingʼs global Defined Benefit investment performance database. The median size of the funds in the database was US$1.7 billion.

We believe one of the reasons why internal management performed better, and will continue to perform better, is cost. On average, each incremental per cent of internal management saved 0.30 basis points in cost relative to external management during the 13-year period.

Fund Size

A second likely factor is fund size. Funds with more internal management tend to be larger. Larger funds have a cost advantage due to economies of scale. Larger funds are also better able to attract and retain skilled internal managers, have better access to the best external managers, and are more likely to have a well-developed organizational structure with control and feedback mechanisms.

The asset classes most frequently managed internally by Canadian funds were Canadian fixed income, Canadian stocks, and real estate. U.S. stocks and foreign non-U.S. stocks were less frequently managed internally.

In general, internally managed active holdings outperformed externally managed active holdings. Internal active management outperformed external active management in Canadian stocks, U.S. stocks, Canadian fixed income, and real estate. External management outperformed internal management in foreign non-U.S. stocks. These results are shown in Table 1.

The superior performance of internally versus externally managed active holdings, observed for Canadian funds, was similarly observed for funds in our global universe. Here, internal active management outperformed external active management in U.S. small cap stocks, non-U.S. stocks, and global real estate. External management outperformed internal management in U.S. large cap stocks. There was no performance difference between management styles in global fixed income.

Given the superior performance record of internal management, the average proportion of assets under internal management in our Canadian universe was surprisingly low – only 16.2 per cent in 2004. The low level of internal management was similar to the level reported in other regions. The average proportion of assets under internal management was 13.5 per cent in our global universe and 8.9 per cent in our U.S. universe.

Significant Decline

While the proportion of assets under internal management in Canada was slightly higher than the global average, the proportion overstates the level of internal management in Canada. The Canadian average was comprised of a small number of funds that used a high level of internal management and a large number of funds that used a low level of, or no, internal management.

Indeed, in 2004, 54 per cent of Canadian funds used no internal management whatsoever. How did these funds perform? Funds that used no internal management reported an average net value added of 3.5 basis points in 2004 compared with a Canadian average net value added of 38.1 basis points.

Over the past 13 years, assets under internal management, as a per cent of total assets, declined by one-third from 23.6 per cent in 1992 to 16.2 per cent in 2004. The decline was consistent across different sized funds. The decrease was most pronounced among large funds with assets in excess of $3.4 billion. In this group, the percentage of assets under internal management dropped from 90.6 per cent to 32 per cent.

There was also a significant decline in the proportion of funds with more than five per cent of assets under internal management. Funds with more than five per cent of assets under internal management, as a percentage of all funds, dropped from 42 per cent in 1992 to 33 per cent in 2004. Given the relationship between net value added and internal management, the low and declining levels of internal management may be detrimental to value creation.

Hubert Lum is research director for CEM Benchmarking Inc.

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