Public asset owners typically externalize strategically for specific geographies or asset classes where they can learn from external managers’ expertise. Some more sophisticated institutions go as far as running a concurrent external and internal strategy to explore new asset classes. One sovereign wealth fund professional said that it employs both internal and external desks and “plays them off each other.”
In alternatives, public asset owners’ first forays are often through direct investments and acquisitions of real estate. As they gain sophistication and confidence, many co-invest with external third-party institutions, while others add private equity, hedge funds and hedge funds of funds to their portfolios. At their most sophisticated, public asset owners can act as quasi-private equity shops themselves, leading sourcing, due diligence and strategic investments.
Public asset owners also seek out external managers to achieve improved performance and benefit from additional services, such as market insights or reporting. Only a small minority say cost benefits are a primary driver when hiring external managers.
Not only are there a variety of approaches taken to internalization and externalization, but the balance between the two approaches changes over time. Unlike operating models, which are much more static, the ratio of internal and external management is highly dynamic, with two-thirds of institutions planning to change their strategy over the next five years (see Figure 2, “The Majority of Public Asset Owners Will Change Their Mix of Internal and External Portfolio Management”).