As interest in OCIO, or outsourced chief investment officer, programs continues to grow, institutional asset owners are delving into the fiduciary, operational and oversight issues. OCIO refers to discretionary investment management, either partial or full, that asset owners delegate to a third-party provider. Cerulli Associates has estimated that OCIO assets will rise to $1.7 trillion by 2023 from $1 trillion today. Two OCIO experts — Jim Link, managing director at PFM Asset Management, and Ian Toner, chief investment officer at Verus — explain why institutional investors have become more attracted to OCIO, clarify how a board’s key governance responsibilities shift under OCIO and offer practical insights on the key benefits and challenges of these programs.
Jim Link: What’s driving our clients and the people that we are talking to is time and focus. Endowments and foundations have missions, pension funds have constituents and beneficiaries to deal with, and both have a lot of areas to focus on other than picking managers. That desire to focus on mission and to conserve time [to take care of] some of the other really important priorities for those institutions has driven folks to think about outsourcing.
Ian Toner: That’s exactly right. The key question that any board faces is how best to use their time. For many boards, they can better spend their time on the needs of the organization by providing oversight and governance of professional investors after setting the guardrails and the structure, [and] identifying the enterprise risk tolerance and perhaps the ESG [environmental, social and governance] values of the organization. While providing governance over that, they can spend the rest of their time on mission-critical areas for the organization, such as fundraising, project development, program development and so on. The ability to bring in a fully fledged, experienced investment team to help with the strategic side of the investment program, and to then implement the intermediate and tactical side, gives the board much greater flexibility to use their strengths and skills in a more focused way to advance the organization.
P&I: Do you expect this interest to continue?
Toner: It is likely that interest will continue because the advantages of an OCIO structure will become more broadly apparent. However, not every organization should be in an OCIO structure, and that’s a governance question for the board. Secondly, the core element of the OCIO process is the investment component. It’s really important that you have a robust investment proposition at the heart of the OCIO offering that can continue to draw interest. Third, there’s a degree of tailoring that will continue to be increasingly important: Customizing the nature and structure of the process alongside the real underlying needs of the organization, rather than simply using an off-the-shelf approach, will probably have a greater mind share in the marketplace. And finally, there’s been a recognition that complexity and sophistication are not the same thing.
Link: I would agree that this will continue to expand, and it’s part of [the] continuum of this trend since the ’70s or ’80s. It’s part of a natural evolution of the investment process. Back in the day, you would have had a portfolio of possibly three investments — an S&P 500 fund, a Bloomberg Barclay’s Aggregate-type of fund and cash — all with one manager. Then we evolved into the consultant model, where the consultant rightly said one manager can’t be the best at everything, and so you got into diversification and asset classes. Now, what you’re seeing is complexity in portfolios to the extent where individual trustees and board members are having a really difficult time understanding these portfolios. So the OCIO model has come in and will continue to evolve. I agree that not everybody is, or should be, in an OCIO model, though it works for a lot of folks. What this evolution will look like 10 years from now, I’m guessing, won’t look exactly like it does today.
P&I: What types of asset owners should be considering OCIO and why?
Link: Asset owners who have a pool of assets without the capacity to have professional staff focused exclusively on investment management should be looking hard at it. The ability to bring a team of investment professionals into the fold while maintaining your strategic fiduciary duty is key. It would be silly to say that some of these multibillion-dollar funds that have an internal investment team need to avail themselves of OCIO. But where you do need OCIO is in a large majority of middle, upper-middle lower-middle funds in terms of size.
Toner: This gets to the heart of the OCIO conversation with investors. This is a governance question. So it’s not directly related to size, although the bigger you are, the more you are likely to be able to have an investment staff. It’s not directly related to board capabilities, although there’s an element of which decisions the board feels comfortable keeping or delegating that varies. There’s an element of the importance of the investment program to the organization as a whole; for some it’s a small part of the picture while for others the investment program is really important to the mission.
The way we suggest owners of capital think about this is to simply say, This is one of the core elements of the governance matrix you need to think about as fiduciaries. What governance structure do you want in place? What decisions are going to have to be made? Who will make the decisions and who will oversee those decisions? How will those decisions be assessed? Some of those decisions sit with the board and always will, some are appropriate to delegate given the structure of the organization, and from that comes a conclusion about whether OCIO is a good solution for them or not.
P&I: Once the board delegates investment management to the OCIO, what is the impact on their fiduciary responsibilities?
Toner: First, it’s important to remember that the board remains responsible for the pool of money. There is the delegation of some elements of the decision-making process in investing those assets, with the exact decisions that are to be delegated determined by the owner of capital. But they remain responsible for the success of the program. As I said earlier, the enterprise risk tolerance and customization really drive much of this decision-making process. Enterprise risk tolerance is about the ability of the organization to withstand shocks, the risks they’re prepared to run, the return they need, their resilience. And customization involves how you build an investment process that fits around that and delivers or increases the probability of the investor achieving the goals they’ve set. It has to be a grown-up conversation around the table by the board, where everyone is comfortable with what the investment program should look like.
Link: The point Ian made about the strategic issues — whether you define that as the risk tolerance or the asset allocation that reflects that risk tolerance and those kind of decisions, — [these] are things that we don’t believe the board can or should ever jettison. It is, in fact, that strategic guidance — maybe with a lot of education and a lot of input from their advisers — from the board that forms the fundamental underpinning of how that portfolio of assets is going to be managed and the expectations for the OCIO. You can certainly outsource the manager selection and the day-to-day execution, but strategic-level issues remain front and center for the board.
P&I: Could you elaborate on the difference between a traditional consultant and an OCIO manager?
Link: The way we look at the difference between a traditional consultant and an OCIO has entirely to do with the fiduciary duty of the execution. Both can help with the strategic discussion, make recommendations and provide input at the strategic level to help the board make its decisions about the investment portfolio. The real difference comes when you look at the execution of that strategy, whether the core strategic part or the tactical part. In the traditional consulting model, the board retains the fiduciary duty with the selection of managers, the tilting of portfolios and implementation things like that. [With OCIO programs], executing those areas is, in large measure, delegated to the OCIO[s]: They make the manager decisions and allocation decisions. There has to be a material amount of trust between a board and their OCIO, because when the board turns over some of those execution elements, they have to (a) understand how the OCIO is executing and (b) trust the OCIO will carry out [the board’s] fiduciary duty appropriately.
Toner: We, as an organization, have both nondiscretionary and discretionary clients. We have long experience doing traditional consulting and believe [that] real benefits [come] from our [consultants’] skill set working with and educating boards to help build understanding of long-term goals, asset allocation structure and that all-important term, enterprise risk tolerance. Our people interacting with OCIO clients don’t wear an OCIO hat or a non-OCIO hat only — they all have clients of each type. At the same time, you need to have a broad and deep investment capability to help make and implement those decisions. Asset owners need to look at the consulting skill set, paired with broad and deep investment capability, as important parts of an effective OCIO program, whatever type of firm delivers it.
Link: We would agree, because we grew up originally as a traditional consultant and have morphed into what is effectively an entirely OCIO firm. We do have a few nondiscretionary clients that are legacy clients. But I absolutely agree that a traditional consultant takes a different approach from a money manager. A consultant is primarily an educator and an information purveyor. That is critically important because the one thing that most clients in the OCIO space need is clarity and education. Most board members are lawyers, accountants and executives in other fields. [They] are very well educated but are not necessarily deep in the investment market. They need information so that they can make the decisions.
Toner: I sit on three different committees: I chair one school endowment, co-chair the finance and audit committee for the Seattle Metro Chamber of Commerce and am a member of a local foundation finance and audit committee. These are very different organizations with very different people around the table with very different levels of experience, and those differences mean that the best approach to portfolio construction is different in each case. The most important thing to get a successful outcome is to understand that everyone around the table, whatever their background, is equally a part of the decision-making, setting goals and targets, and understanding the enterprise risk and potential outcomes. The skill set to get that consensus is key to the front end of the OCIO process, and it needs to be paired with the investment competence to deliver the back end of the investment process.
P&I: For asset owners considering the OCIO model, where do they need to start?
Toner: First, understanding the big picture, understanding the strategic role that the investment portfolio plays in the organization, understanding the idea of risk and its relationship with return, understanding which decisions they want to keep as a board or as a committee and which decisions they want to delegate; and then understanding how those decisions are going to be assessed, both the ones they keep and the ones they delegate.
Link: The single-biggest thing that the board has to come to terms with, in our experience, is how their role changes and how it stays the same. Where are the differences and where are the similarities? As an example, they can never give up fiduciary responsibility for the strategic oversight of the portfolio. Sometimes it’s difficult for board members to understand ‘How do I carry out my duties under this new model? If I’m still responsible for the strategic level, but I’m not responsible the execution and implementation, how do I properly oversee my OCIO? What should I be looking at and evaluating them on?’ That’s a big part of what they need to understand.
P&I: What is required for the strategic oversight of an OCIO manager?
Link: The board needs to (a) understand the philosophy of their OCIO, and how that philosophy is going to be manifested; and (b) look at performance and risk in their portfolio, and decide whether they believe that the OCIO is carrying out their duties as they expect. It’s not a lot different than from any other money manager. The OCIO is a money manager across a bunch of asset classes. My personal belief is that OCIOs should have composites. It may not be perfect, but some aggregate representation of your performance record, if you’re taking discretion, should be presented.
Toner: That’s exactly right. The hardest thing at times is building the understanding that when you’re making these long-term decisions, particularly in the investment space, some work, some don’t. So it’s engaging with the OCIO provider: talking about the things that work, the things that didn’t work; making sure that the process that’s underlying the investment process is the one that you expected to happen [and] that the provider is engaging properly with clear evidence of the decision-making that they’re doing, focusing on performance. Again, having composites and robust performance metrics is really important.
P&I: Should an OCIO client expect a custom solution?
Link: It depends on how you define customization. A client should expect a portfolio that effectively represents and reflects their goals, their risk tolerance and the return expectations necessary to meet their mission. If that’s what custom means, I agree. If custom means I have to pick a different manager for each client so that it feels like it’s different, I disagree. You should look to your OCIO to be executing with their best ideas as it applies to your portfolio. In some cases, that means private equity and private debt in real estate; in others, [it] doesn’t. In some cases, that means a heavier allocation to passive index portfolios or a different macro asset allocation. All of that is on the table for customization, but in the context of goals, risk and mission.
Toner: We would say that customization is at the heart of a successful OCIO program. But you must be clear about what you mean by customization. It’s not a question of picking different managers for every single client just to look different. It’s an integrated investment viewpoint, which is then implemented in a way that makes sense for clients in terms of asset allocation, portfolio construction, manager selection and so on. Customization is not product-ized. It is tailored to the specific needs of the individual client but based [on] a broad, deep investment-insight-producing team that is going to rhyme appropriately across all the different organizations, depending on their enterprise risk tolerance.
P&I: What are some current concerns that you’re hearing about the OCIO model?
Toner: The concerns will generally come out if the governance model isn’t right or the portfolio that’s built isn’t in line with the risk tolerance and governance nature of the organization. For example, “sophisticated” strategies are often very illiquid. That can lead to dissatisfaction with a portfolio [that] is very illiquid, tied up in a way that hampers the work of the organization, because they may suddenly need access to capital that they can’t access as effectively or they need to sell more liquid assets than they’re comfortable doing. That’s not a problem with illiquid assets in itself. That’s a problem with the governance model not working correctly, the enterprise risk tolerance conversation not having happened correctly or maybe a bit too much off-the-shelf happening. You need to have broad and deep investment capability with deep understanding of enterprise risk tolerance and governance structures to deliver an effectively working OCIO relationship.
Link: That’s a really good answer and I’m going to take a different direction on this one. One concern we’ve heard people talk about and, candidly, that we believe is a concern, is the use of proprietarily manufactured products. Some big firms in the marketplace are touting themselves as OCIOs and they mostly use their own investment management underlying products and services. We fundamentally believe that it’s really hard to have an honest and balanced assessment of your own product. It seems very hard to us to have an open discussion to determine the kinds of things that Ian is talking about if there is a different profit motive or a different business imperative. I’m not here to suggest that they’re all wrong all the time. But I am suggesting that that is a risk in the governance model that a client really needs to examine before they jump into it.
Toner: I’ll add that we also have no proprietary product at Verus. We believe very strongly in unilateral alignment toward the client. ■