Have you ever attended a networking event with people from different industries who all introduce themselves in industry jargon? “I’m a PLP at EMC in charge of implementing ERP solutions.” That’s usually a good cue to head off in another direction.
The investment industry is no different – we may even be the worst offenders. When Alpha Capital Management performs investment consultant searches or OCIO searches for our clients, we generally work directly with finance staff and investment committee members. It may sound obvious, but even in these circles, we’re not speaking directly to investment professionals on a daily basis. Diversity of thought is valuable to investment committees, and members without investment experience play an important role by asking questions, checking assumptions, and approaching decisions from different backgrounds. Studies show that 70% of the members on a typical volunteer non-profit investment committee have investment experience – so on average, at least 1-2 people in the room with us on any given engagement are not investment experts (nor do they play one on TV). We try our best not to use a lot of industry lingo, but we aren’t always successful.
Here’s a great example: OCIO. This is a term we use constantly – in fact, it is at the heart of many of our client engagements. The first decision that an investment committee needs to make is whether to “go OCIO” – that is, whether to outsource any of the investment decision-making functions that currently rest with the committee. But before a committee can make that decision, each of the members need to know what we mean when we use the acronym OCIO.
With that in mind, school is now in session. Welcome to OCIO 101.
What is OCIO?
“OCIO” is an acronym for Outsourced Chief Investment Officer.
Many large organizations, especially in the non-profit world, have Chief Investment Officers (often shorted to “CIOs”) who oversee their investments. A well-known example is David Swensen, who has been Chief Investment Officer of Yale University’s $30B Endowment since 1985. Organizations can also choose to outsource this job to an external firm, hence, an outsourced CIO or OCIO.
To understand what an OCIO does, it helps to first understand two things:
What does a Chief Investment Officer (CIO) do?
At Yale, CIO David Swensen’s ultimate job is to earn Yale strong returns on its investment portfolio. His and other CIO’s typical job responsibilities are a mix of portfolio management, people management, and investment operations. A university’s CIO might:
But not every institution is as big as Yale and can dedicate a salaried position (let alone several) to investments. Many institutions (especially those with less than $500M in assets) do not have a dedicated Chief Investment Officer and find ways to split up these duties across other staff members (the Chief Financial Officer is a common choice) and volunteer Investment Committee or Board members. Often, the Investment Committee will hire one or more experts to assist them. Enter the Investment Consultant.
What does an Investment Consultant do?
The most common arrangement in the industry, for a long time, looked like this:
Under this arrangement, everything rests on the shoulders of the volunteer Investment Committee. As we learned earlier, most Investment Committees are not comprised entirely of investment experts, nor do they have the time and resources to perform the heavy lifting on investment due diligence. These Committees need advice and analytical firepower to help them make the big decisions they are tasked with – namely, how to prudently invest the assets under their care so that those assets can meet the organization’s needs, and hopefully also grow over time. This is the role that the Investment Consultant plays – an outside firm hired by the Investment Committee to provide advice, do the heavy lifting on asset allocation studies and investment manager due diligence, and to help the Committee discharge its fiduciary duty.
Under this model, the Investment Committee makes portfolio decisions based on the advice of the Investment Consultant, and the Chief Financial Officer or other staff implemented those decisions by performing tasks such as signing documents and moving assets.
What does an OCIO do?
The traditional arrangement we described above still exists, but it can be a heavy burden for an Investment Committee, and it is becoming more so over time. As investment consulting firm Callan wrote in their 2019 paper, "Risky Business Update: Challenges Remain for Today's Investors," an institution could expect to earn an annualized 7.5% return in 1989 just by investing in bonds and cash. In 2019, to earn the same expected return requires a diversified portfolio with stocks, real estate, and even private equity. It has become harder for Investment Committees to oversee these portfolios as they grow in complexity.
It is no surprise, therefore, that OCIO (outsourced Chief Investment Officer) has taken off like a rocket in the past ten (really the past five) years. It shifts some of the Investment Committee responsibilities and some of the Chief Financial Officer responsibilities onto a new player, the OCIO, who replaces the old Consultant. Like this:
Under this model, the Investment Committee oversees portfolio strategy. The OCIO makes portfolio decisions based on the strategy the Investment Committee has outlined in its Investment Policy Statement. The OCIO is also empowered to implement many of those decisions, including signing documents and moving assets. The Chief Financial Officer or other staff serve in a supporting role.
What Kinds of Firms Act as OCIOs?
Based on what you've learned so far in this course, you may have already guessed that two of most popular types of OCIOs are:
These two groups aren’t the only ones with the right skill set to offer OCIO solutions to institutions. Other OCIO providers who have leveraged existing services to build discretionary solutions are:
Are All OCIO Models the Same?
Let us repeat, NO!
Just as OCIOs evolved from a variety of different firms, there are a wide number of potential OCIO models to choose from. Here are three main groups of OCIOs (noting that real life does not conform nicely to these groups, so there is plenty of variation. The value of a well-written OCIO RFP to suss out these nuances cannot be overstated):
Alpha Capital Joins with Nasdaq to Create OCIO Tools to Increase Transparency
New suite of indices provide valuable tools for institutional investors to measure outsourced Chief Investment Officers
Alpha Capital Management, a best-in-class OCIO search provider, announced the Alpha Nasdaq OCIO Indices, a suite of tools that empower institutional investors with valuable insights for assessing Outsourced Chief Investment Officer (OCIO) services. Alpha Capital collaborated with Nasdaq in developing the product suite, which provides much-needed transparency to a traditionally opaque industry.
The indices give institutional investors and OCIO firms the ability to objectively measure their performance against peers across different risk profiles, client types and asset mixes. Alpha Capital developed the indices along with Nasdaq and leading OCIOs.
Outsourced Chief Investment Officers are third-party service providers that serve as chief investment officers for institutional investors. They assume the legal and fiduciary responsibilities of a Chief Investment officer but provide the services externally. A report by Charles Skorina & Company estimated OCIO assets under management grew to $2.38 trillion this year.
The Alpha Nasdaq OCIO Indices provide a reliable framework for institutions to objectively measure the performance data of these providers, which has traditionally been difficult to assess. The tools are a meaningful step towards establishing an industry-wide standard for OCIO performance evaluation.
The indices are based on account-level return streams, asset allocation and metadata anonymously reported directly by OCIO firms. The Alpha Nasdaq OCIO indices compile this anonymously reported data to construct a family of indices that represent the broad OCIO market along with variations of the OCIO market to more appropriately reflect the nuances across sub-categories, such as client type and risk profile.
“For too long, outsourced CIOs were measured by a wide variety of metrics that didn’t suit every player,” says Brad Alford, of Alpha Capital Management. “The Alpha Nasdaq OCIO Indices help create a level playing field and bring some transparency and uniformity to how OCIOs are measured. This is a game changer for institutional investors looking into outsourcing CIO functions and for OCIOs.”
“Market access and transparency are two of Nasdaq’s key missions,” said Terry Wade, Senior Vice President of Business and Product Development with Nasdaq’s Global Information Services. “Our work with Alpha Capital Management brings much-needed transparency and makes the OCIO space more accessible.”
For more information, please visit www.AlphaNasdaqOCIO.com.
The outsourced Chief Investment Officer ("OCIO") service model has a lot to recommend it. Institutional portfolios grow more and more complex, putting strain on corporate benefits departments and non-profit volunteer boards. Institutional clients need more help, and the marketplace is busily coming up with solutions to meet strong client demand. Investment consultants have been very successful in offering OCIO solutions to clients. Indeed, three of the five largest OCIOs globally are investment consultants. The OCIO model offers several attractive features to investment consultants, but it also comes with challenges. We address three such challenges in this blog post: performance, conflicts of interest, and operational capabilities.
Challenge #1: Performance
A constant source of frustration at our firm during our searches is trying to get an investment consultant to quantify the value of their advice (one reason we think they can’t charge as much as they should). Who is responsible for returns in a non-discretionary investment relationship where a board of directors makes decisions based on the advice of their investment consultant? The board selected the asset allocation, but the consultant did the asset allocation study. The board picked the managers, but the consultant recommended them. It’s hard to parse out who is responsible for performance in an advisory relationship.
With OCIO though, performance responsibility rests squarely on the consultant-turned-OCIO, good or bad. Take a look at this statistic from Cerulli’s most recent OCIO research study: 100% of non-profit respondents list investment performance as the #1 thing an OCIO must deliver.
We don’t believe that consultants have fully embraced responsibility for performance yet. When prospective clients ask for performance, a common refrain from consulting firms is, “we cannot show an OCIO track record because every client is different.” Clients may have different goals, but relative performance or composites of clients with similar goals should capture these. (As a side note, without an industry standard like Global Investment Performance Standards (GIPS) being used, even composite returns must be viewed with suspicion. But it is still a step in the right direction! For more on GIPS, see our 2018 blog post).
Institutions must be able to see a track record in order to judge whether an OCIO is likely to deliver their #1 expectation, investment performance. OCIOs must accept responsibility for investment performance.
Challenge #2: Operations
One reason OCIO is so popular for non-profits under $250M (who, as a rule, are chronically understaffed) is operations. Investment portfolios have gotten extremely complex. Paperwork can be a nightmare, especially for alternatives with partnership agreements, side pockets, capital calls, distributions, and everything else to manage. Operational efficiency is a big selling point for OCIO solutions, but it’s also one where consultants don’t have a natural skill set - they must build it or buy it.
It also presents an interesting conundrum for consultants selling OCIO solutions to investment committees. Investment committees make the investment decisions, but they usually don’t know how the sausage is made. Operations staff handle portfolio implementation, but they don’t sit on investment committees. Consultants tie investment discretion and operational authority together into one OCIO package, but committees may view these as completely separate decisions. And committees may not want their consultant to sell them new and expensive investment solutions, which brings us to our third challenge.
Challenge #3: Conflicts of Interest
One thing the institutional investment consulting community does exceptionally well is align their interests with their clients. These long-term relationships are built on the client’s ability to trust their consultant. Serious conflicts of interest (like accepting money or Masters tickets from asset managers, earning 12b-1 fees and other commissions in addition to advisory fees, or selling proprietary products) are rare in the consulting industry these days, and those that exist are typically well disclosed and well managed.
Offering OCIO services alongside non-discretionary services, however, opens the door to brand new, serious conflicts of interest that must be managed. Now consultants have something to sell non-discretionary clients, OCIO, that increases revenue. Consultants are building proprietary products in an attempt to scale OCIO solutions – another potential conflict. Consultants are held wholly responsible for OCIO track records but not for non-discretionary client performance, incentivizing them to allocate top quartile, limited capacity managers to OCIO clients in the hopes of improving their performance record. The fee differential between non-discretionary and OCIO clients incentivizes firms to allocate their best resources to the line of business with higher revenue potential. These are just a few examples.
The OCIO industry is just beginning to grapple with these serious conflicts. Consulting firms must find a way to offer OCIO services without breaking the trust of their clients. We encourage consulting firms to think carefully about the potential conflicts of interest inherent in offering OCIO alongside traditional non-discretionary services, and to proactively and transparently address those issues with well-designed policies. December performance woes may be forgotten by mid-January, but clients have a long memory for bad behavior. It is time for the OCIO industry to evolve.
This blog post is adapted from our research report, "Clients Give Consultants a Green Light for OCIO."
Virtually unheard of a decade ago, the outsourced Chief Investment Officer (“OCIO”) marketplace has exploded. OCIO providers had more than $1.7 trillion in fully discretionary or partial discretionary assets under management (“AUM”) in early 2018, on a projected base of over $6 trillion total “outsourceable assets.” OCIO assets in the US have grown significantly over the past decade, and OCIO assets under management are expected to continue to grow at low double-digit rates for the foreseeable future, according to projections from Cerulli Associates and Pensions & Investments. In fact, Cerulli projects that US OCIO assets will increase by $671 billion over the next five years alone.
With such attractive growth prospects, it is no surprise that all sorts of firms are entering the market to offer institutional OCIO solutions. Alpha Capital Management tracks nearly 100 different firms offering OCIO services. Many of the OCIOs who have been most successful in attracting clients are consultants.
In this blog post, Alpha Capital Management offers our thoughts on the three primary reasons investment consultants are embracing OCIO. Our next blog post will cover three challenges that consultants-turned-OCIOs face.
Reason #1: Clients Want It
OCIO is growing because clients demand it. Why now? Let’s look at a few real-life examples from Alpha Capital Management’s search clients.
A $200M frozen pension plan finally saw their funded status top 90%. The CFO was thrilled. But by the time they went to lock it in, the markets moved against them. When we were called in to do a search, the funded status was back in the mid-80s. This number was so important to the CFO that he asked finalists if it could be pushed to him daily via text message. They went OCIO.
Pensions like our search client are a huge part of the OCIO market. This was true five years ago, and it is still true today. As Pensions & Investments reported in June 2018: “Large managers of discretionary OCIO assets said one of their biggest sources of new business in the past year and expected to be going forward is from corporations contemplating the fate of their defined benefit plans.” Defined benefit plans have kept pace with the massive growth of OCIO and still represent a third of the global OCIO marketplace, as shown below:
Here’s another example. We worked with a non-profit with about $500M in assets. Their returns weren’t awful, but they were below their peer group median and trailing public market benchmarks over the past 3, 5, and 10 years. “We must be terrible at managing money,” thought the board. They went OCIO.
It has been a tough market cycle for diversified investors like our non-profit client. The S&P 500 has beaten InvestmentMetric’s entire institutional universe, as shown here:
Of course, we are not arguing that the S&P 500 Index is a fair comparison, or even a reasonable one, for a diversified portfolio. But it is undeniably a visible, well understood, and highly discussed benchmark. Even against the simple blended index shown above, institutional portfolios have not kept up with the US market. Broad index returns may not mean as much as meeting client-specific goals and objectives, but these comparisons still matter to clients.
We believe that OCIO has benefited from two massive tailwinds: pension plan sponsors who seek an improved governance model, and clients struggling with underperformance issues who seek stronger returns.
Reason #2: Increased Revenue Potential
The marketing pitch we hear for OCIO goes like this: “it leads to stronger governance and an improved decision-making process, and it allows investment committees to focus on strategic decisions rather than getting bogged down in the details of running a complex portfolio. The service model bears an increased cost to compensate for the additional fiduciary liability of the OCIO.”
Consultants may not charge enough for advisory work (although our clients disagree). Try going to your advisory clients and asking for a 100% fee increase – you’re more likely to get fired than to get a client to agree. OCIO, though, has given consultants the opportunity to reset the market perception of value. An institution may be willing to pay twice as much for OCIO. This is an important factor in the explosion of OCIO offerings by consultants.
Reason #3: Scalability
OCIO also offers an attractive opportunity for consultants to grow more quickly using scalable solutions. Traditional investment consulting services are hard to scale. Portfolio management can be simpler and more scalable under an OCIO model. Instead of a consultant with 10 clients performing 10 individual asset allocation projects and 10 manager searches with 3 candidates per search, an OCIO does one asset allocation project and hires one manager per slot and then pushes it out to all 10 clients. It can be an attractive model from a business management perspective while offering clients a strong investment solution (and it ties back into the second point, as scalable solutions allow for higher client loads and therefore more revenue).
No Wonder Consultants are Embracing OCIO
The relationship between a client and an investment consultant is a long-lasting one, and clients place a great deal of trust in their consultants. It is no wonder that clients are approaching their investment consultant as they try to navigate increasingly complex governance considerations in a challenging market environment. Consultants are well placed to offer OCIO solutions to these clients seeking more help, and indeed, we see that they are successfully doing so.
Still, we believe consultants are finding OCIO to be a two-edged sword. With the benefits of higher fees and a more scalable service model come several key challenges.
In our next blog post, we will focus on three main ones: performance, operations, and conflicts of interest.
This blog post is adapted from our research report, "Clients Give Consultants a Green Light for OCIO."
As outsourced Chief Investment Officer (“OCIO”) solutions become more popular with institutional clients, the need to compare firms on a quantitative basis grows greater. If you’ve spent any time talking about the OCIO model with Alpha Capital Management, you’ve likely heard us mention GIPS compliance as an issue.
Performance is one important way to draw clear comparisons between investment managers (though, of course, it is not the only factor to consider). Most investment managers in traditional asset classes, 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 (i.e. alpha). GIPS is not as common yet in the alternative investment space, although that is expected to change in the near future with many hedge funds working toward GIPS compliance. The CFA Institute has been working on a project called GIPS 2020 aimed at improving the standard and increasing adoption, and it is expected to propel adoption of GIPS among alternatives managers. We hope it does the same with OCIOs.
We request performance information in our RFPs, but it is a highly imperfect metric. Traditional investment consultants are not usually compliant with GIPS, and performance varies widely between clients due to varying investment policy restrictions, use of alternative assets, individual investment managers, and whether the client implements the consultant’s advice. Many firms provide us with representative account data, which may or may not be relevant to our client. Although some OCIOs invest client assets as a pool where it is very easy to show audited performance, customized OCIO providers face the same issues that traditional consulting firms do: clients have different investment restrictions, different managers, and different objectives.
That being said, as OCIO Strategic Investment Group recently said “Yes, OCIOs Can Be GIPS Compliant!”
What is GIPS Compliance?
GIPS is an established set of principles that standardize the calculation and reporting of investment performance. The GIPS standards are voluntary and based on the fundamental principles of full disclosure and fair representation of performance results. GIPS allows investment management firms to quantify and communicate their performance without misrepresentation. Reference the Global Investment Performance Standards Handbook from the CFA Institute for more information on the standards, which is available for download at the CFA website.
Any investment management firm can follow the guidelines set forth by GIPS when calculating its track record, but only firms that manage discretionary assets can claim compliance with GIPS. Compliance cannot be attained by a single product. A firm must follow all requirements of the GIPS standards across all of the firm’s products, or else it may not claim compliance. Moreover, each and every client must be included in one of the composites. The CFA Institute’s GIPS Standards website lists more than 1,500 firms who claim compliance. To date, few OCIOs are among them.
Why is GIPS Compliance Useful for OCIO Searches?
Simply put, an institution’s ability to judge the OCIO’s ability to beat their benchmark over time, with comfort that the numbers are not cherry-picked or massaged, is paramount in selecting a qualified OCIO. There are several complicating factors to consider, however.
Some OCIOs use “building blocks,” where they establish track records for asset class composites like global equity. Examining those records helps gauge skill in manager selection (and to some extent, the ability to combine managers). But what about asset allocation? Unfortunately, looking at building block records doesn’t show if an OCIO has skill in asset allocation, either strategic or tactical. A true GIPS composite gives the institution valuable insight into the ability of an OCIO to manage a total portfolio.
GIPS compliance also helps to compare firms on an “apples to apples” basis. In the searches Alpha Capital Management runs for large institutions, we receive performance information that is all over the map. Some firms send us gross numbers, many send us gross of their fee but net of the underlying manager fees, and very occasionally, we get “net-net” numbers (meaning net of underlying management fees AND net of any OCIO fees, representing the end client performance). GIPS would simplify this greatly.
Exhibit 1 shows a sample GIPS compliant presentation. It is clear why this is valuable. Not only does the recipient have performance information, but he also has key information necessary to verify the quality of the data going into that calculation.
There are some caveats. As discussed earlier, a firm claims compliance with GIPS. An individual strategy cannot be GIPS compliant; every strategy at the firm must be assessed and calculated in line with GIPS, and every account must be put into a composite. For OCIOs with asset management divisions, claiming GIPS compliance can be a very complicated, time consuming, and expensive endeavor. It also reduces a firm’s ability to be flexible in regards to how it shows performance, as it locks the firm into one set method of calculation (even for issues where GIPS allows some leeway, such as in the treatment of legacy client assets, the firm must choose a path and stick to it).
There are also many flavors of OCIOs. Some OCIOs offer significantly customized solutions across their client base, while others offer a single pooled investment strategy that all of their clients use. For the latter, GIPS compliance is much more straightforward than the former.
What are the Market Trends?
We’ve been loudly complaining about the lack of GIPS compliance by OCIOs for quite a long time. For reference, we wrote a piece last summer in which we remark, “it’s ironic that consultants who would never hire an investment manager without a track record ask to be hired without providing their own” (Outsourced CIO: Not a Silver Bullet). We can also point to a recent survey conducted by eVestment and ACA Compliance Group, which showed that three quarters of investment consultants will not consider managers that don’t claim compliance with GIPS for their performance data some or all of the time. (see FundFire's "No GIPS? No Mandate for Most Managers: Report" by Mariana Lemann from August 16, 2018)
In our own OCIO searches, our institutional clients have been focused on performance as a differentiator between firms, and they have been frustrated by the complexity of analyzing the data they receive. This issue matters to the institutional investors who allocate to OCIOs and have the power to demand transparency.
We believe that the client demand for transparency and comparability between providers will lead to GIPS standards being more widely adopted by OCIOs. We’re happy to see already that more OCIO firms are talking about GIPS compliance or making progress toward claiming compliance. Strategic Investment Group was an early adopter, as was Angeles Investment Advisors. Highland Associates and Aon recently announced GIPS compliance, and we have spoken to several other OCIOs or consulting firms who are in various stages of reviewing, calculating, or claiming compliance with GIPS.
We firmly believe that the industry will reach a “tipping point” where the major players are GIPS compliant, and competitors must follow their example to stay relevant. The move toward transparent, verifiable performance calculations is a great thing for investors, and we highly encourage it.
We applaud OCIO and consulting firms who have recognized this and are taking action. We hope to be able to exclude firms who do not claim compliance with GIPS or have audited numbers from our OCIO searches, but right now, there are not enough compliant firms to do so. As the OCIO industry develops, institutionalizes, and evolves, we think that adopting clear, verified standards of performance is the best possible way for institutions to differentiate between OCIO providers’ performance. We will do all we can to usher in this new era of transparency.
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Why Hire a Search Consultant
Are you thinking of engaging a search firm to help you run a consultant search or OCIO search? You’re not alone. Although practically unheard of five years ago, the outsourced CIO (“OCIO”) model, in which a committee hires an investment manager to oversee the portfolio rather than soliciting advice from an investment consultant, has exploded onto the institutional landscape and has garnered significant interest from a wide range of institutions. The investment world has gotten increasingly complex, and more and more boards, committees, and organizations are unsure of their ability to truly fulfill their fiduciary obligation to the assets they oversee (at a time when fiduciary lawsuits are on the rise). OCIO models offer a solution for organizations struggling with a lack of internal resources, a desire to improve governance process, and the need to improve risk-adjusted returns. The traditional investment consulting model has evolved to fill these needs, but at the same time, it has complicated the investment advice landscape.
This added complexity has led to a new niche service provider: the consultant or OCIO search firm. These are sometimes referred to as “OCIO Search Consultants,” but we believe this terminology is confusing as consultants historically provide investment advice while OCIO search firms provide very targeted services to enable organizations to vet investment advice and implementation providers. We like to say, “don’t call us a consultant!” OCIO search firms exist to guide organizations through the search process, everything from designing the RFP and developing search criteria to identifying candidates and analyzing the responses. More than one-third (34%) of providers polled in a recent industry survey by Cerulli used a search firm, and this number continues to grow. They manage the entire project from start to finish, greatly simplifying this important fiduciary process for institutions.
Our Keys to a High Quality Search Firm
Ten Questions to Ask Search Consultants
It may seem silly to go through an RFP process to hire a firm to run your RFP process, but as a leading search firm, we often receive “mini-RFPs” with a handful of questions designed to compare us against our competitors. As RFP architects, it makes sense to us from a due diligence perspective. We encourage firms to consider this exercise, and to help, we compiled 10 sample questions that organizations can use to learn more about search firms.
With outsourced investment options (commonly called OCIO, which is how we’ll refer to these in the remainder of this report) becoming more popular in the institutional investment community, we have considered what types of governance issues an OCIO might be able to solve for organizations and investment committees.
This is not to say that OCIO is only useful for dysfunctional committees, but it is true that we usually get calls when something is broken. Sometimes this is related to the consultant: performance hasn’t met expectations, or the client feels that the consultant isn’t proactively managing the relationship, or perhaps there has been turnover on the account. But governance is also a key concern, and many of our clients and prospective clients have wondered if OCIO could solve a nagging problem: absentee investment committees.
Absentee committee member archetype
Having served on the boards of non-profits and having worked with many more as consultants and endowment directors, we understand this particular governance problem intimately. It can take many forms.
The serial volunteer: Bob’s biography proudly lists his participation on the boards of several well-known non-profits, but he rarely attends scheduled investment committee meetings and does not participate in most discussions or decisions.
The dog ate my homework member: Susan attends scheduled committee meetings but has not done the background reading and preparation needed to add value to investment discussions; valuable meeting time is spent answering her questions.
The one whose cousin is a broker: Anita loves to bring new investment ideas to the table – unfortunately, most are either too expensive or too esoteric for the committee to invest in. They also have not been vetted by an independent consultant. Valuable time is wasted both for the committee and the investment consultant researching and rejecting these investments.
The pillar of the community: Anything Randall says goes, even if most of the investment committee thinks it is the wrong decision. After all, no one argues with Randall. He has been on the board for over ten years.
What all of these archetypical volunteers have in common is a tendency to distract the investment committee from its purpose. Too much time is wasted in valuable committee meetings, time that is needed to set the broad direction of the investment portfolio and monitor the service providers. You can’t force grown-ups to do their homework, especially not volunteers, but political considerations usually mean that organizations also cannot simply replace problem members.
Solutions for a thorny issue
There are several potential ways to handle this thorny issue, including:
Exploring Option 4 - OCIO
We’ve been asked, is there really a difference between effectively rubber stamping a consultant’s every recommendation and simply giving them discretion to make the decision?
In our minds, there are three primary differences:
1. The level of oversight
As with any industry and any firm, some investment consultants are more skilled than others. OCIOs should have policies and procedures in place where investment decisions are vetted and approved. This ensures that one consultant doesn’t “go rogue” or make decisions that don’t reflect the best thinking of the firm.
In the case of a traditional investment consultant relationship, there may not be the same level of consulting firm oversight – after all, the committee members are the additional level of oversight in the latter case. If the committee is not performing that level of oversight and simply takes all of the consultant’s recommendations on faith, a committee had better hope they have an A-team consultant guiding the portfolio!
2. The fiduciary liability
You cannot pay someone to completely absorb your fiduciary liability. Full stop.
The investment advisor, whether a non-discretionary consultant or OCIO, acts as a fiduciary alongside the investment committee, but the level of fiduciary responsibility differs. In an OCIO relationship, the committee does shift its fiduciary liability from evaluating the investments themselves to evaluating the advisor, but they must still fulfill this duty. The buck always stops with the committee.
3. The feeling of personal responsibility
At the end of the day, a consultant who only provides advice may not feel personally responsible for the assets he or she advises on - especially if performance suffers when the consultant's recommendation is not taken. The level of responsibility is vastly higher for a named investment manager than it is for an advice provider. An investment manager lives or dies based on the results of his or her portfolio. A consultant, put simply, does not.
These distinctions tilt the scale in favor of absentee committees seriously considering OCIO solutions. However, it’s important to note that ultimately, this does NOT solve the tricky problem of a checked-out investment committee in our minds. Why not?
Who oversees the OCIO?
The committee retains the fiduciary duty to evaluate the OCIO provider, both initially and on an ongoing basis.
To evaluate investment managers (and we include OCIOs here, as they effectively act as multi-asset managers for the portfolio) requires a specialized skill set. In fact, that’s one of the main services that an investment consultant provides in a traditional, non-discretionary consulting relationship.
Most investment committees include members with financial services experience or investment knowledge, often enough to set big-picture investment policy decisions and to weigh in on the long-term asset allocation of the portfolio. Investment committees are usually responsible for these tasks in either traditional non-discretionary or OCIO relationships, so we agree that this is the appropriate skill set to look for when selecting investment committee members. Unfortunately, this is not the same skill set required to perform in-depth due diligence on managers.
Investment committees who choose OCIO as a bandage, therefore, have not solved the initial problem of non-engagement, and they have created a higher bar for themselves in fulfilling their fiduciary duty.
The committee who was not fulfilling its previous fiduciary duty to evaluate investment managers based on advice given by a traditional investment consultant is not likely to suddenly start fulfilling this exact same role when it comes to evaluating the outsourced portfolio manager, the OCIO.
The committee must consider using an additional service provider in these situations: an investment expert who can perform an evaluation of the OCIO.
The value of a third-party OCIO evaluation
As outsourced investment solutions become more popular for institutions such as pension plans, endowments, and non-profit asset pools, so too do third-party evaluation and monitoring services who assist the investment committee in properly selecting and overseeing the OCIO.
These providers act as a “consultant” to the investment committee, assisting the committee in performing its crucial fiduciary responsibility of selecting, overseeing, and evaluating the outsourced investment solution. Typically, this review is performed annually and should be well documented. Just as OCIOs come in many flavors, so too do OCIO evaluation services. They range from truly independent advisors, who offer no institutional investment consulting or OCIO services of their own, to investment consultants and outsourced CIOs who serve in a monitoring capacity for non-investment clients.
We believe that there is great value in selecting a truly independent option, as consulting firms have a baked-in conflict of interest that can color the analysis. Just as the investment consultant should be providing advice independent of relationships with investment managers, monitors should provide advice independent of consultants.
For most institutions, running an investment consultant RFP or OCIO RFP is an occasional (and painful) process. There isn’t much value derived from previous RFPs since the intervals are too far apart. Offering this as a service, we have an opportunity to constantly improve and evolve our search process, including the questions in the RFP themselves. It allows us to pinpoint what works and what doesn’t. With that in mind, here are five of our favorites.
Update: we're pleased to announce that this report was featured in FundFire on December 15! Download your copy here.
1. What percentage of firm revenue comes from institutional consulting activity? Identify other sources (and %) of revenue.
Rationale: The lines have been blurred between investment managers, consultants, and outsourced chief investment officer (OCIO) providers – especially over the past few years. Although we typically include many questions in an RFP designed to identify potential conflicts of interest, this question gives us a birds-eye view of the firm’s revenue. We use it as a way to gauge the firm’s commitment to providing traditional consulting services versus OCIO services and/or investment management services. It also alerts us of existing business lines that we may not have captured in other questions and allows us to clarify this in conversations with the respondent.
2. What is the average client-to-consultant ratio at the firm, and how is it calculated?
Rationale: It was an investment consultant who clued us into the various ways this question can be answered. Some firms simply compare the number of clients to the number of investment professionals to calculate the ratio (thus including dedicated research professionals and support staff along with client-facing consulting professionals). Others only include consulting team members. One firm differentiated between lead (counted as 1 client) vs. co-lead (counted as 0.5 clients) relationships. In order to compare firms on this metric, it is important to get consistent responses and to understand how this metric is being calculated. We ask several questions about the client to consultant ratio, but this is the primary one we use for comparison.
3. Provide comments and suggestions on our current Investment Policy Statement (included with the RFP).
Rationale: What better way to evaluate a new advisor than to ask for advice in the RFP? When a new consultant is brought on board, the first step is often a review (and possibly, an overhaul) of the organization’s existing investment policy statement (IPS). Most of the time, these changes are cosmetic – for instance, a particular consultant may prefer wider bands around target allocations. But we have seen a few cases where prospective consultants identified potentially serious issues in a client’s IPS, including internal inconsistencies. Even if the organization stays with the incumbent, this question gives the organization comfort in the integrity of their IPS and documents a thorough review process with input from some of the best minds in the business.
4. How do you ensure best ideas are shared between consulting and research teams?
Rationale: The bigger the firm, the more likely it is that there are consultants and researchers spread across different departments and different geographic locations. The best research capabilities in the world won’t do a client any good if the consulting team isn’t receiving, processing, and funneling this information to the client. Ensuring that there are strong processes and procedures in place to keep these lines of communication open is a way of ensuring the client benefits from the full capabilities of the firm.
5. How do you measure your success as a consultant? Provide data as support.
Rationale: Much as our firm is constantly evolving and improving our RFP questions, consulting firms are evolving and improving their responses. They have carefully crafted qualitative answers to show off their skill set to the best of their ability. This question is a way for the client to quantify each firm based on the results of their advice (not an easy thing to do with consultants!). It also provides insight into what the consultants themselves think is important, which can be very helpful in setting criteria.
Bonus: Here's one that didn't work
Not all of our questions are successful in helping us to evaluate and differentiate between investment consultants. Here's one we tested out that didn't work very well:
What is the average client to senior consultant ratio for relationships in the following size ranges?
A) Less than $100M
B) $100M to $500M
C) $500M to $1B
D) $1B and greater
Rationale: Where questions are open to interpretation and gamification (such as the client to consultant ratio), we request different data points and ask for the information in different ways. This allows us to cross-reference the responses and ensure that the answers are consistent. We used this question (unsuccessfully) in a recent RFP.
We expected to see a higher client-to-consultant ratio on smaller clients (with AUM representing a crude measure of complexity) and a lower ratio on larger clients. Overall, the measure should be in line with the high-level client-to-consultant ratio.
40% of the firms we asked didn’t track this data and most of the rest didn’t provide consistent information in line with expectations. One firm, for example, came back with 1:1 in every category, which we believe signified one senior consultant assigned to each relationship (i.e. the consultant to client ratio, rather than vice versa).
Rather than try to reengineer this question, we simply removed it and rely on other measures to place the client to consultant ratio in context.
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