In an increasingly complex environment of regulatory mandates and investment options, endowments, foundations and pension plans are taking a tack widely accepted in the post-trade communications market: outsourcing the critical functions of a chief investment officer.
“They [asset owners] can easily create an investment policy — what they will or won’t invest in — but when it comes to making more complex decisions on asset allocation, selection of fund managers and monitoring of those fund managers they are turning to external help,” says Timothy Ng, chief investment officer for Clearbrook Global, a New York-based investment management consultancy.
Firms such as Clearbrook Global provide so-called outsourced chief investment officers, or OCIOs for short, who serve as high-level wizards directing multiple pieces of the investment equation. Practically speaking they are replicating internal CIO functions even going as far as to hire all of the third-party service providers, such as custodian banks and fund administrators.
Why the mounting interest in OCIOs? Endowments, foundations and pension plans are often required by their organizing principles to keep their costs down. As a result, they may have to rely on overworked internal staff doing the critical strategic work on a part-time basis at best, and can’t afford the more elaborate infrastructure necessary to obtain the highest performance results. Pension plans — relative newcomers to the OCIO market– often have the extra impetus of being underfunded and at risk of being unable to meet their obligations to retirees unless they can improve their investment returns. .
Choices abound
An endowment, foundation or pension plan can contract an outsourced chief investment officer to handle the entire portfolio or part of the portfolio. It can even delay a decision until competing contenders prove themselves. “As the OCIO business is in its nascent state, it may be difficult for institutional investors to simply discern who are the best and most qualified firms to provide these services,” says Ng. “Therefore, a pension plan may select two providers for a period of time to assess their investment capabilities, their ability to work with the fund’s board and their capabilities to provide excess performance against a pre-determined return benchmark.” The OCIO firm best able to meet client needs will be kept on, while the other one will be terminated.
Yet another reason for using multiple outsourced CIOs is expertise in a particular asset class, such as hedge funds, venture capital, private equity and real estate funds. “Although experienced OCIOs will be up to speed on all asset classes, for those seeking to outsource part of the portfolio, the best use of an OCIO will be in the area of alternative investments,” says Bruce Myers, managing director of investment advisory firm Cambridge Associates, which provides OCIO services.
That is because most internal CIO departments and boards of directors are far more knowledgeable in equities and fixed-income products. They may not have sufficient expertise to conduct a due diligence analysis on a hedge fund manager, when there are thousands of smaller or newer managers from which to choose. Allowing the plan to rely on what it knows best and using the OCIO service on what it knows best can ultimately reduce the downside risk and increase performance returns.
Of course, the easiest option is to simply rely on one OCIO firm to handle all of the work involved, as using multiple ones requires substantial monitoring on the part of the endowment, foundation or pension plan may raise administrative costs. Most OCIOs will charge asset management fees pegged to the value of assets they must monitor, while a few will also charge performance fees if they exceed a certain agreed upon benchmark.
Careful Decision
The right OCIO can be a critical factor in ensuring successful returns. Selecting the wrong OCIO can result in disappointing investment returns from either part or all of the assets, as well administrative problems and costs from issues such as having to migrate from one fund manager to another. Consultants, asset managers themselves, and banks with asset management arms such as Nothern Trust offer OCIO services and are registered with the Securities and Exchange Commission as investment advisors. They can be sued for wrongdoing — aka breaching their fiduciary responsibilities — as glaringly evidenced in a recent case involving JP Morgan as an OCIO provider.
Having sat on several investment committees of endowments, foundations and pension plans evaluating OCIO services, Don Steinbrugge, managing partner at hedge fund consultancy Agecroft Partners in Richmond, Virginia, reports that the decision is a lot tougher than it sounds. It could take months to find the right match simply because the relationship isn’t meant to be a short-term liaison. It lasts on average three to five years and even more than a decade in some cases.
The track record of an OCIO service is critical, and so are fees, pedigree, expertise with specific asset classes, and overall quality of process, according to Steinbrugge who cites the following questions as critical: Does the OCIO have sufficient staff to do the work and has it done similar work in the past? Has it managed similar assets and similar investment strategies? Does it have experience with the same type of client — either an endowment, foundation or pension plan? And does it have a good system in place to select and monitor each of the fund managers hired? Cash flow needs and investment time horizons differ depending on the type of investor with endowments usually having the longest and highest allocation to alternative asset classes.
As is the case with all outsourced roles, a combination of the right relationship management and technology is critical to ensuring a correct system of checks and balances. Investment boards should typically meet with the OCIO firm’s representative on a regular basis. Steinbrugge recommends monthly briefings for accounts over US$100 million in size, quarterly briefings for those between US$10 million and US$100 million in size and semi-annual ones for smaller accounts. Such interactions start with the OCIO’s written performance report and specific information about the portfolio and overall market conditions, followed by a Q&A session with the board.
Of course, the OCIO also needs to be on top of any quick market downturn or abrupt underperformance by a particular fund manager and be proactive in contacting the investment board directly, rather than being notified by the board. “OCIOs will need to have the right portfolio management plan to access information on a daily basis from each of the fund managers they are monitoring,” explains Ng, whose firm relies on the InvestorForce system. That information includes what assets they are buying and selling, the daily valuation of the portfolios and valuations of any hard-to-price — aka non-exchange — traded securities including any changes.
Common Problems
Although setting up the correct oversight process can go a long way to preventing errors, there is plenty that can and will go wrong. For one, there could be friction between a internal CIO and external CIO teams overseeing certain asset types. So its always best to have internal teams bless the selection of the OCIO. Differences over the use of a particular investment strategy, such the level of exposure to alternative investments, can turn what should be a symbiotic relationship into a tumultuous one which, if not corrected, will ultimately hurt investment results.
Naturally, the savviest OCIO service will be eager to diffuse a potential client management issue before it escalates. “Although the OCIO may have valid and concrete reasons to include a particular asset class or strategies within a client’s portfolio, should a client’s internal CIO team not be comfortable with them, the OCIO will typically defer to the wishes of the internal team,” says Ng.
Yet another source of potential conflict: a misunderstanding of how the OCIO is handling the structure of the portfolio. It could opt to invest all of the monies in a single pool of assets, which is managed by multiple managers but has strict limitations on when holdings can be redeemed by the investor, explains Myers. Not knowing that limitation could put an endowment, foundation, or pension plan at risk for not being able to withdraw money when it needs to. The far better approach: allocating a percentage of the total value of the portfolio to each fund manager as separate accounts with diverse terms. Doing so could provide sufficient liquidity for the client, and allow the OCIO to have a better handle on the performance of each fund manager.
Poor oversight by the client is the most common, yet avoidable source of problems. Therefore, it is important for endowments, foundations and pension plans to know just how the OCIO is monitoring the investment process. If the OCIIO doesn’t have close to real-time knowledge of just what the fund manager is doing, the relationship may not work for the client. A solid portfolio management system by itself won’t be enough as it will only aggregate the necessary information provided by the multiple asset managers on a daily basis.
Whatever the frequency of incoming information, the OCIO’s staff will have to quickly make certain there are no anomalies. A fund manager may have purchased or sold the wrong asset or the invested in the wrong hedge fund or other alternative fund. “It’s best to know at the end of the day instead of days or even weeks later if a mistake has been made, because it can be rectified with little to no financial impact to the client,” says Ng. As a rule of thumb, the longer it takes to uncover and fix the error, the higher the potential cost to the fund, particularly in a highly volatile market environment. In the case of a manager buying or selling the wrong security, it is the manager’s responsibility to rectify the error without any financial repurcussion to the underlying fund. Should the error be due to a mistake with sector and regional exposures — aka they fell outside an agreed upon set of investment guidelines, the manager must also quickly cure — or rebalance the client’s portfolio.
While relying on an outsourced chief investment officer might seem novel, it is no different than hiring an outsourced chief compliance officer or outsourcing a middle and back office task. A rigorous selection process, good communication and ongoing performance monitoring are keys to a successful relationship. Also understanding from the get-go that being a wizard is part of the job description may help in locating the OCIO that can really make a difference.