Outsourced Chief Investment Officer (“outsourced CIO” or “OCIO”) solutions have exploded in popularity in the past few years – although these types of relationships have existed for far longer. What is an OCIO? In the classic investment consulting relationship, an organization (for example, a corporation, government office, endowment, or foundation) works with a consultant to determine an appropriate policy and asset allocation for the investment pool. The investment consultant monitors the pool and advises on asset allocation changes, investment manager replacements, and other related issues. The organization retains discretion over the investment pool and may choose whether to follow the consultant’s advice; hence, these are “non-discretionary” relationships. In a discretionary (or OCIO) relationship, the consultant has the ability to implement changes without direct approval from the organization, acting as the chief investment officer.
As a consultant search service, we help organizations select investment consultants. These days, most clients ask about OCIO – even when the purpose of the search is to replace a non-discretionary investment consultant. Given the current level of attention OCIO commands in the news, it is not surprising. However, there is a significant amount of misinformation floating around the industry regarding outsourced CIO providers, and some carry a great deal of risk for organizations. OCIO is sometimes touted as a miracle cure or silver bullet. We hope to address some of the most common – and most dangerous – misconceptions in thinking about OCIO providers.
OCIO ABSOLVES AN ORGANIZATION OF ITS FIDUCIARY DUTY
We see this alluded to frequently in marketing materials from OCIO firms. Unfortunately, it is wrong. Nothing can release an organization (and by extension, a Board of Directors) from its fiduciary duty. Outsourced CIO providers can serve as co-fiduciary, but the organization remains a fiduciary for the investment pool. The organization also has the duty to evaluate the OCIO service provider on a regular basis, just as they have with a traditional consultant. It is tempting to turn things over to an OCIO and focus on other responsibilities (indeed, it’s one of the selling points of this service), but the organization puts itself at risk with this behavior.
OCIO IS A NEW SOLUTION
This one is widespread but not particularly dangerous. OCIO has existed, under one name or another, for over twenty years. This type of arrangement is especially common in the endowment world, where investment teams broke away from larger endowments and created specialized investment models for use by small-to-mid-sized endowments and foundations. In recent years, however, the use of the “outsourced CIO” moniker has risen in popularity – and the number of firms offering these services has exploded. Even traditional investment consultants are getting into the space, with many now offering services along a spectrum from non-discretionary to full discretion.
OCIO FEES ARE SIMILAR TO TRADITIONAL CONSULTANTS
As with any business-to-business solution, price and service levels vary widely between firms. Fees for OCIO solutions are often two to three times more annually than a non-discretionary investment consultant. Given high dispersion and the lack of a standard service model, plan sponsors and institutions must carefully evaluate the costs involved and the services provided in each firm’s quote to fulfill their fiduciary duty. We recommend that organizations issuing an OCIO RFP request bids from a few firms who offer non-discretionary options (or both). This provides a benchmark when assessing fees.
OCIO PAYS FOR ITSELF
As we have just learned, OCIOs can cost significantly more than traditional investment consultants. One explanation for the difference is the level of service provided. OCIO providers like to say that it costs less to outsource than to build capabilities in-house. That depends. A 0.30% annual fee costs a $350M organization over $1M in fees per year, which could probably pay for an internal CIO, an assistant, and third-party investment research. Another justification OCIO firms use to downplay their fees is that outsourcing requires less support staff to implement investment changes (filing documents, initiating money transfers, etc.). In our experience, staff members spend only a fraction of their time on investment-related activities. Without proven investment results and measurable decreases in payroll, OCIO fees can prove hard for organizations to swallow.
OCIO FIRMS HAVE RESULTS
Performance is one way to draw clear comparisons between investment managers. Most investment managers, especially those who work with institutional clients, claim compliance with Global Investment Performance Standards (GIPS), a globally accepted methodology for calculating and presenting performance information. Prospective clients are able to directly compare investment manager results to measure skill. It’s ironic that consultants who would never hire an investment manager without a track record ask to be hired without providing their own.
Although we request performance information for representative client accounts in our non-discretionary and OCIO RFPs, it is hard to evaluate. Traditional consultants are not usually compliant with GIPS, and performance varies widely between clients due to varying IPS restrictions, use of alternative assets, individual investment managers, and whether the client implements the consultant’s advice. It seems that OCIO providers should clear this hurdle and be able to provide GIPS compliant performance (and there are some who do) – however, more customized OCIO providers face the same issues that traditional consulting firms do; clients have different investment restrictions, different managers, and different objectives.
OCIOS MINIMIZE CONFLICTS OF INTEREST
Many OCIO firms (and traditional consulting firms) offer proprietary investment vehicles. These can take many forms, but a common one is an alternative fund-of-funds (for instance, private equity or hedge funds). These proprietary funds have potential benefits, including access to alternatives for smaller clients. But they also have potentially serious conflicts of interest. An OCIO firm has an incentive to invest clients in their fund-of-funds to earn more fees (if, for example, the fund includes performance incentives or management fees). In the private wealth world, this is known as double dipping, and the SEC takes it seriously. We have seen firms who rebate these fees back to their clients and others who do not. Investors need transparency into the layers of fees they pay to their OCIO providers as well as information on other potential conflicts of interest.
No solution is perfect for every client. With these misconceptions cleared up, our hope is that organizations can make the best decision to meet their needs, whether that is OCIO or non-discretionary consulting or something else entirely. OCIO is certainly not a silver bullet, but it can be a great weapon for an organization. Unsure if it is right for you? Interested in evaluating your options? Give us a call — we are happy to share our perspective.
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CONSULTANTS GET THE ONE-TWO PUNCH: HEDGE FUNDS & ACTIVE MANAGEMENT
We believe 2017 will go down as the year with the highest turnover of investment consulting relationships since the aftermath of the 2008 financial crisis. We assist institutions with investment consultant searches, so we have a ringside seat for the action, and we are amazed at the number of RFPs going out so far this year. One consulting firm we spoke with has already received double the amount of RFPs that they do in a typical year – and we aren’t even 6 months in. Considering that 20-30% turnover is normal in this business, this is a significant increase. Institutions are ready to make a change – but why now?
We have spoken to several consulting firms and institutions about this, and we have identified two major themes driving this uptick in activity.
THEME 1 : ALTERNATIVES-HEAVY PORTFOLIOS OUT OF FAVOR
Alternatives have become a common component of many institutional portfolios over the past several years, with hedge funds serving a key role. Given the complex nature of these alternative-heavy investment portfolios, consulting firms had a strong value proposition to offer these institutions: identify the top managers with intensive research and due diligence using the firms’ extensive resources. Hedge funds performed well in the 1990s and through the 2000-2002 downturn; in fact, many of the best fund managers became household names (Julian Robertson, George Soros, and their peers). Unfortunately, hedge funds did not hold up as well in the 2008 downturn, with the average fund down about 20%, and they have struggled ever since. With one large component of the portfolio seemingly out for the count, we have reached a tipping point for investment committees, organization staff, and plan sponsors to reevaluate their alternatives exposure – and with it, the consultants who recommended it.
THEME 2 : PASSIVELY MANAGED FUNDS OFFER CHEAPER, BETTER RESULTS THAN ACTIVE COUNTERPARTS
In institutional circles, popular media, and the private wealth space, active is out. Investors want results, and cheap, passively managed investments have delivered better results than expensive active managers in this market cycle. Institutions and their advisory boards have embraced passive management for many reasons, including lower fees but also continued political backfire from active investment performance. Yet we continue to meet with consulting firms that believe active management is the only way to go in a portfolio.
One argument we hear is that active management outperforms over long periods of time (8-10 years) thanks to superior downside protection. Unfortunately the tenure for most board members is shorter than this record-breaking bull market. The board is ultimately responsible for the welfare of the investment portfolio, and the financial and emotional toll of an all-active portfolio in this market environment is already high and keeps rising. Consulting firms that disregard the role of passive investments in a portfolio increasingly do so at their own peril.
Only time will tell the winner as consulting firms continue to evolve in this new investment paradigm. Though these two themes dominate many conversations we have with investment committees and plan sponsors, the fact remains that governance best practice calls for a review of service providers every five to seven years regardless of performance. If you are interested in retaining an RFP consultant to guide you through the process, we would be happy to share our perspective.
Brad Alford, CFA