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!
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.
Anna Tabke, CFA, CAIA