Commentary on the performance of Australia’s super funds normally focuses on investment alpha – the value added that comes from active decisions in relation to fund investments.
However, there has been much less focus on operational alpha – which is the value added from the adoption of new processes and procedures that permanently reduce costs and boost efficiency as opposed to the ‘benchmark’ of peer fund cost structures.
In short, operational alpha is the value added from everything other than the actual decision process of investment.
Operational alpha is becoming a more important concept. As they continue to grow, most of the largest super funds are increasing in complexity.
Complexity includes the fragmentation of overall portfolios as they are spread over increasing numbers of external managers and/or asset classes.
In essence, growth brings the risk of diseconomies of scale through fragmentation of fund structures.
One of the reasons why operational alpha has not been discussed much within super fund boards is that cost benefits tend to be defined in particular ways.
The costs of running entire funds are often thought of in terms of total management expense ratios (MERs).
Sometimes, boards consider the costs of individual asset classes against the benefits of those asset classes.
For instance, hedge funds/alternative assets generally cost more than actively managed equities and bonds (which, in turn, cost more than passive equities and bonds).
However, hedge funds are expected to provide protection of the entire portfolio at times of market volatility.
The super funds’ response
Some of the larger super funds are appointing designated executives, who are responsible for generating operational alpha on a whole-of-fund basis through functions like centralised portfolio management (CPM) or central liquidity management (Treasury-style functions).
These executives usually have broad investment management and operations experience, however they may or may not have principal responsibility for tax matters.
CPM separates the art of investment management from execution functions.
It may also involve the assumptions of functions that might otherwise be undertaken by the super fund’s custodian.
CPM can be used for deferral of capital gains tax (CGT) liability, trading (internal crossings, management of soft dollar costs, gaining the benefit of direct broker relationships), securities lending, FX and cash management.
In the most pure form, CPM reduces the role of external investment managers to providers of model portfolios.
In this case, the investment managers are valued for their insights in relation to the asset classes on which they are experts, and their compensation reflects this.
Broadly speaking, a super fund can carry out CPM in two ways. One way is to rely on an in-house CPM executive and their team to undertake most or all of the functions that can generate operational alpha.
The other approach is to delegate responsibility for CPM to a specialist third-party provider.
Often functions that can be carried out via CPM may – or, indeed, should – be done in partnership with the fund’s custodian who maintains the overall fund asset positions.
Centralised portfolio management in practice
In relation to trading, CPM can in theory reduce brokerage costs in two ways.
One is to remove soft dollar costs that would essentially be borne by the super fund if the underlying investment managers were responsible for trading.
The other is to negotiate brokerage costs on a whole-of-fund basis. In practice, the super fund may or may not be able to negotiate brokerage deals that are superior to those that could be negotiated by the underlying managers.
In addition, the disengagement of the managers from trading may mean that their useful insights are not implemented in an optimal way.
CPM is essential if the super fund is to have the ability to cross securities from one underlying portfolio to another without incurring the costs of buying and selling through the open market in the event that managers trade against each other.
Interestingly, our experience in Australia is that the savings that are directly attributable to internal crossing of securities are minimal given the complementary manager selection process – but as funds grow ever larger this is a consideration for the future.
CPM works well in relation to securities lending, notwithstanding that this is a service that custodians have been providing successfully to super funds for some time.
The implementation of various regulations (eg. Basel III) that change the way banks calculate, allocate and apply capital to trading positions has created opportunities for large super funds to leverage their strong and stable balance sheet.
In essence, the largest funds are seen as alternative counter-parties for specific transactions. This has changed the approach to lending to being more effective as a partnership – with shared and complementary roles.
However, this does require accountable executives within the super funds managing this closely with the custodian lending team to extract additional yield for the fund.
CPM also works well for netting and bulking of FX transactions.
However, the larger custodians can undertake this function at low cost. Unlike, say, internal crossing of securities, netting and bulking of FX transactions does not need CPM.
Another issue is that many international fixed-income portfolio managers see FX management as an integral part of their overall investment process – it is challenging under the existing mindset for them to separate FX decisions from other decisions in relation to bonds and derivatives and free up funds to benefit from custodian fund wide netting of transactions.
In relation to cash management, CPM may or may not produce operational alpha relative to the delegation of the function to the custodian.
The benefits from CPM will depend on a number of factors: 1) the efficiency of the super fund in managing cash balances; 2) the ability of the fund to sweep cash from the portfolios that are handled by the underlying managers; 3) and whether or not the super fund can achieve higher rates on cash deposits than the custodian.
We would suggest that the benefits of CPM in relation to cash management have decreased over the last few years as the rates that the custodians have been able to achieve have become more competitive.
Expect to hear more about operational alpha
In short, CPM can generate operational alpha. Given the absolute size of Australia’s largest super funds, the sums that can be saved (or made) for members through an appropriate focus on operational alpha are substantial.
Nevertheless, CPM is not a panacea. While there are some functions (such as in-house crossing of securities; tax parcel selection) that can only be handled through CPM, there are areas of operational alpha where the custodian is well placed to provide support – such as improved centralised FX; securities lending programs that are more customised and dynamic in supporting different fund initiatives and support for liquidity management solutions.
Nonetheless, the benefits and risks of CPM (whether pursued in-house, through a CPM manager or with the custodian) will be discussed more by super fund boards in the coming years, as the boards seek to generate operational alpha for their members.
Seamus Collins is the executive director and senior relationship manager at JP Morgan Investor Services.
