An OCIO's ability to add value from active management is constrained by the asset classes the fund permits and the ranges within which the portfolio must be rebalanced. To make performance comparable across OCIOs, then, we need to remove any effects that made it harder — or easier — for some OCIOs to outperform benchmarks.
For example, it is harder to outperform the policy portfolio when:
- Fewer asset classes are permitted.
- Rebalancing ranges are tight.
- Policy weights are high in markets that are more efficient.
- Opportunities to add value are limited.
Inflation-linked bonds might be good for funds with liabilities that rise with inflation, and are therefore included in the policy portfolio, but they offer fewer opportunities to outperform the benchmark (mainly duration) because the benchmark has few bonds and they are of similar quality (i.e., U.S. Treasuries).
Alternatively, OCIOs add value more easily when one or more of these strategies are permitted: tactical asset allocation; active currency hedging; certain hedge fund strategies; or private equity. In these four strategies,there's typically an inverse relationship between the capital used to implement the strategy (low) and tracking error taken (high). This low/high relationship between capital/risk creates an advantage because tracking error is allocated more efficiently in this case, all else equal.
To remove these effects, performance should first be analyzed at the asset class level and only later at the total fund level.
Also, greater care is needed in private markets, where valuations (and therefore returns) are less reliable than public ones, benchmark quality is low and because it takes years to deploy private capital (i.e., "vintage year" plays a big role).