OCIO 102

If you haven’t taken our OCIO 101 class, you may wish to start there. It covers what OCIO stands for (outsourced Chief Investment Officer), what its namesake Chief Investment Officer does, and what kinds of investment firms offer OCIO services.

Today, we’re diving a little deeper into the OCIO landscape. Deciding to hire an OCIO is one important decision an Investment Committee can make, but it is not the only one. Once an organization has chosen to move to an OCIO model, it must select between the myriad options that bear the “OCIO” label.  The three OCIO models we will discuss today, which we think of as a spectrum, are:

This class, OCIO 102, is dedicated to helping you make sense of those labels to find the OCIO model that best fits your organization’s needs. We also offer some tips to organizations embarking on a search for each model.

One-Fund OCIO

At one end of the spectrum are one-fund OCIOs (at least, this is what we call them at Alpha Capital Management).

These are complete solutions, primarily for endowments and foundations, and they are typically managed by spin-outs of large endowment teams like college universities. When an institutional investor engages a one-fund OCIO, the institution’s assets are combined with all the firm’s other clients in a pool and invested in the same asset allocation with the same managers. One-fund OCIOs typically invest in a version of the Endowment Model, with heavy allocations to illiquid alternative investments.

Benefits

• Invest in a fully diversified pool on Day 1. No J-curve for private equity, no ramp up period as investments are identified and selected, just a full allocation to the total portfolio.
• Pooled assets can be leveraged to secure fee concessions from investment managers and meet investment minimums. This is especially helpful for smaller investors.
• In the due diligence phase, prospective clients can view audited track records that represent actual client experiences (this is rare in the OCIO industry for several reasons. Refer to our paper on OCIO performance to learn more.)
  

Considerations

• Customization is very difficult (though no longer impossible in some cases).
• Costliest OCIO model on average. The funds are capacity constrained, and the smaller number of clients means that each client bears a proportionately higher cost to maintain a high quality investment team.
  
• Terminating a one-fund OCIO is not a straightforward process. Liquidity terms at the OCIO level can be one year or more, on top of the liquidity of the underlying investments like private equity.

Alpha Capital's Search Tips for One-Fund OCIOs:

1. Clarify your investment objectives and investment philosophy at the outset of the search. Hire a one-fund OCIO with strong alignment in these key areas.
   
2. Consider divorce before getting married. Make sure exit parameters are clear.

Work well for organizations who:

• Have perpetual time horizons and target returns in excess of inflation plus annual spending requirements (CPI+5%), such as endowments and foundations.
• Lack internal investment resources and seek to outsource nearly all portfolio management decisions to prudent experts.
• Believe illiquid asset classes like private equity are key to achieving their return targets, but who lack the networks and manpower to cultivate relationships to invitation-only funds on their own.

Challenging for organizations with:

• Significant internal investment resources and/or engaged, connected investment committees who wish to play a hands-on role in the management of the assets.
• Different spending goals or liquidity needs/restrictions than the typical endowment or foundation.
• Special investment restrictions like fossil fuel free investments.

Custom OCIO

At the opposite end of the spectrum from one-funds are custom OCIOs.

This model looks and feels very similar to legacy investment consulting relationships. Custom OCIOs take a collaborative approach to many of the high-level portfolio decisions that one-fund OCIOs make on their own – liquidity, return objectives and risk tolerance, asset class weights, and idiosyncratic portfolio decisions like values-based investing. On these big-picture topics, there is no functional difference between a custom OCIO and a traditional non-discretionary investment consultant. The line in the sand that separates custom OCIO from non-discretionary consulting is the ability to hire and fire investment managers without approval from the organization. Once the Investment Policy Statement has been collaboratively created and agreed upon, the custom OCIO has discretion to make day-to-day portfolio decisions, and it has the operational authority to do so.

Benefits:

• Organizations may customize portfolios and integrate investment ideas such as values-based investing.
• Terminating an OCIO is straightforward, as all assets are held in the client’s name.
• Familiar for organizations used to a traditional consulting relationship. May enhance governance while keeping the investment committee in a key role.
• Least costly OCIO model on average.
  

Considerations:

• Portfolio must be built from the ground up, which takes significant time and effort on the part of the OCIO and Investment Committee. Illiquid investments are subject to the J-curve.
• OCIOs may be able to use the combined buying power of their clients to secure investment minimum waivers and pricing concessions from investment managers, but it may not be as effective as when the assets themselves are pooled.
• Performance is difficult for organizations to evaluate during a search. Many custom OCIOs are reluctant to show composite performance because each client portfolio is different.  
  

Alpha Capital's Search Tips for Custom OCIOs:

1. Carefully evaluate performance. Composite performance should be prioritized over hypothetical constructs and cherry-picked representative clients. Make sure all firms provide you with the same type of return data for apples-to-apples comparisons.
   

Works well for organizations who have:

• Special investment restrictions like fossil fuel free investments, are subject to debt covenants, or have other complications.
• Significant legacy assets, as the OCIO can build a portfolio around these positions.
• Investment Committees who desire to stay intimately involved in the strategic direction of the assets while outsourcing the day-to-day decisions and implementation.
  

Challenging for organizations who:

• Lack the scale required to build diversified portfolios while meeting individual investment manager minimums.
• Struggle with Investment Committee member engagement and decision-making, as the big decisions in this model are not outsourced.
  
• Desire a fully invested illiquid portfolio in the short-term.
  

Hybrid OCIO

Hybrid OCIO is another term that is used by Alpha Capital but not necessarily across the industry. These solutions lie somewhere between custom and one-fund OCIOs on the spectrum.

The distinguishing characteristics of this model are the ability of the client to customize asset allocation (shared with custom OCIOs), and the pooling of some (but not necessary all) client assets (shared with one-fund OCIOs). Hybrid OCIOs often pool client assets within asset classes (e.g. all clients own the same Global Equity vehicle, but the allocation to Global Equity varies based on the individual client’s asset allocation). Some of the earliest OCIOs in the industry use this model.

Benefits:

• Provides a middle ground for committees who do not want or need a totally custom portfolio but are not comfortable moving all assets to one pooled structure.
• Allows investment committees to retain discretion over asset allocation while outsourcing the management of asset classes to investment experts.
• Easier to terminate the OCIO than in a one-fund. However, the liquidity of any pooled assets should be evaluated at the outset. 
  

Considerations:

• Performance is difficult for organizations to evaluate during a search. Many hybrid OCIOs provide track records at the asset class level rather than the total portfolio level.
• Illiquid investments are subject to the J-curve.
• Fees in this model can be opaque. Some hybrid OCIOs charge one fee for total portfolio asset allocation and another fee within the pooled asset class vehicles (this may be bundled together into one quoted fee or provided as two fees). Other hybrid OCIOs do not charge fees within the vehicles.
  

Alpha Capital's Search Tips for Hybrid OCIOs:

1. Make sure you understand how each firm makes money. Is there one OCIO fee and a separate investment fee for pooled vehicles?
   
2. Tread carefully when considering all-in fees. These numbers can easily be manipulated by the percentage of active vs. passive investments priced, the asset class weightings presumed, and others. Many of these decisions are made collaboratively between the OCIO and the organization at the outset of the relationship, and are therefore subject to change.

Works well for organizations who:

• Desire to stay intimately involved in the strategic direction of the assets while outsourcing the day-to-day decisions and implementation.
• Have significant legacy assets, as the OCIO can build a portfolio around these positions.
  

Challenging for organizations who:

• Desire to quickly ramp up illiquid investments or bypass the J-curve.
• Require a high degree of customization at the manager level.
• Are reluctant to invest in pooled vehicles tied to the OCIO.

Other Models Exist

You should now have a solid understanding of the main OCIO models available today. Unfortunately, life isn’t quite as simple as our charming illustration makes it seem. The OCIO industry is in a state of growth and evolution, and there are many variations between custom OCIOs, between custom and hybrid OCIOs, and even between one-fund OCIOs.

One example involves a client veto. Some OCIOs offer clients a defined window of time (e.g. 72 hours) to veto an investment manager change. You may question whether this is truly an OCIO model (remember, the line in the sand is whether an OCIO can make changes in the portfolio without the organization's approval), but it is often sold as such.

Another example involves a fund-of-one at a one-fund (yes, you read that right). As one-fund OCIOs mature, some have started offering clients the ability to customize at the margin. For example, a client with significant illiquid legacy positions may not be able to fully invest in a one-fund’s illiquid portfolio while staying within the liquidity requirements of the organization. This client can get a fund-of-one where the liquid assets of the portfolio are invested like the one-fund but the illiquids are the client’s legacy assets rather than the one-fund’s illiquid portfolio.

Therefore, it is important that your organization looks carefully at each OCIO provider (even if they appear to use the same model) to understand key parameters around discretion, consent, liquidity, fees, investment experience, portfolio management, trading, and other criteria before you hire one. The better designed your RFP is, the easier this process will be for you.

Final Exam

1. What is the difference between a one-fund OCIO and a custom OCIO?
2. What separates an OCIO from an investment consultant?
3. What elements of one-fund OCIOs and custom OCIOs do hybrid OCIOs incorporate?
   

Thanks for taking our class!