Insourcing investment management: handling the operational risks

For large and mid-size superannuation funds, investment management insourcing is now very much on the agenda.

Some of the drivers of this trend are industry consolidation, growth in funds under management and the search for member value through cost control. 

In our experience, there is some diversity in terms of how in-house capability is developed, but in general we think there are two broad categories of experience: 

• Funds that have “evolved” in-house investment capability over time. Typically staff numbers, delegated authority and discretion have grown organically as the size of the fund and assets under management have increased.  
• Large funds that have historically outsourced investment management, but come to reconsider their preferred mix of investment management solutions as the value of assets under management has increased. 

In step with the development of in-house investment decision-making and implementation is the need for a control framework to manage operational and implementation risk.

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Mercer Sentinel has worked with a number of funds to manage the development of in-house investment capability, and we have identified some common implementation risk management challenges. 

Five challenges 

1. Governance 

In an environment of increasing complexity, it can be hard for trustees to be assured that investment implementation is undertaken in a safe and sound manner consistent with both the letter and spirit of the mandate. 

Good governance is a continuum, starting with board policy, which can be traced through to investment delegation and implementation; process and procedure; and finally validation and review.

A key challenge is a governance framework that ensures the board maintains sight of risk mitigation strategies – and comfort that they remain appropriate and within the appetite for risk. 

2. Segregation of duties 

Keeping clear lines of separation between strategy, implementation and control functions are well accepted as an important element of risk mitigation.

However, appropriate segregation of duties, properly supported and reinforced by IT and business applications architecture, can be hard to achieve in small teams. 

Even in larger teams, there may be a separation of functions driven more by the skills of different team members rather than considerations of risk management. Often we see funds exposed to higher risks due to inappropriate segregation of duties. 

3. Spreadsheets and databases 

Spreadsheets and other similar business applications are powerful and flexible tools, which in the context of investment insourcing can be both a blessing and a curse.

It is not uncommon to see reliance on spreadsheets that have embedded business rules and metrics defined by the user.

While potentially very effective as a business tool – and cost-effective in comparison to bespoke investment applications – they pose considerable risk management challenges.  

Spreadsheets and databases specified by the user may lack validation by a third-party, and may be subject to change without proper controls or protocols.

They can also have interdependencies that can lead to small, apparently unrelated events, having material unintended consequences. 

Spreadsheets and other similar business applications, if properly deployed and controlled, can be a considerable resource. The key is to have in place appropriate checks and balances on underlying data and formulae. 

4. Processes and protocols 

One of the most important goals for the investment management team is to translate the investment strategy into economic exposures that match its intentions.

The key to achieving this is developing the right execution and implementation processes and protocols. 

Funds that adopt a ‘best practice’ approach may find the standard they are seeking to meet is either uncommercial on the basis of cost, or impractical to apply.

However, adopting ‘market practice’ may mean applying a standard that doesn’t adequately mitigate risk, and which exposes members to a higher risk of loss. 

In this context, trustees need to seek assurance that internal teams can execute and manage open positions appropriately, but also in a way that balances the often competing demands of cost, and the efficacy of risk mitigation controls. 

5. Talent  

Member experience is linked to the skills and calibre of the investment operations, implementation and risk management team. Identifying, sourcing and retaining the right people is critical to the long-term success of insourced investment management. 

Trustees and fund executives must ensure they have a clear talent management strategy in place, supplemented by a well-thought-out reward strategy. And while financial incentives are important, benefits such as flexible working options and career development are just as crucial in retaining the best staff. 

Conclusion 

The over-arching objective for insourcing investment implementation should always be to maximise the benefit to members.

To achieve that goal, funds need to properly manage the inherent risks of in-house investment implementation, ensure the control environment is effective and take a considered approach to structuring the investment operations function. 

Matthew Heeney is a principal in Mercer’s specialist investment implementation advisory business, Mercer Sentinel.