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."
Anna Dunn Tabke, CFA, CAIA