Pandemic shines spotlight on the importance of trusted relationships
The pandemic has challenged everyone in many ways ― personally and professionally. The coronavirus has forced investment managers and their clients to grapple with yet another black swan crisis just over a decade since the last one. What have we learned so far, especially for the growing outsourced chief investment officer market? What lessons can one take from this experience, and how might they inform the next generation of OCIO providers and clients?
These are the questions and topics OCIO providers have been thinking about even as the COVID-19 pandemic continues to leave its mark around the world.
“Above all else, I see this as a test of governance,” said Bryan Ward, senior partner and North American head of solutions and sales at Aon. “The focus on good governance has been around for a long time but people sometimes underestimate it. While investment performance, outcomes and achieving objectives are all essential, the success or lack of success in any of those areas is a direct function of a good governance process.”
Ward cautioned that in times of crisis, relationships that lack an effective governance process can fall apart quickly. Managers need to be nimble enough to act ― or react ― quickly to unfolding challenges, and they can only do so if the proper authorities and communication channels are put in place from the start.
“If you have a strong governance structure in place, then everything else flows out of that,” Ward said. “Governance comes first. Does your organization have the appropriate governance structure to achieve the objectives that you need and want?”
Jim Link, a managing director at PFM Asset Management, emphasized that “with our clients, the primary area of collaboration is in the up-front planning and building of governance structures, because in the midst of an unfolding crisis, you don't have time to be debating a decision.”
Link said he believes that the OCIO provider and client need to have created not just a framework for decision making, but also the trust that the OCIO can and will execute its duties in line with the client’s objectives in moments of crisis. Such collaboration on governance on the front end can enhance the value of the OCIO relationship on the back end, and it can help prevent one of the things clients fear most: Surprises.
“If you think about it in terms of process and procedure, having deep collaboration up front gives the OCIO the necessary discretion to act in the heat of the moment, but in a way that should never be a surprise to the client,” Link said. “Afterward, the OCIO should follow up that action with documentation about what they did and why they did it, but the time for that conversation is not while you’re in the middle of the storm.”
Good governance is essential, according to Kevin Turner, managing director and head of investment strategy & solutions, Americas Institutional, at Russell Investments.
“We have found from a governance perspective, over and over, that there are a lot of behavioral aspects to managing investment programs,” Turner said. “In times of stress, when markets may not go the way one would like, such as we saw last March, it’s easy for any investor to lose sight of long-term goals. A strong, well-defined governance process helps ensure they don’t capitulate on strategic decisions that have been made to best serve them through the long term.”
Worldwide assets managed with full or partial discretion by outsourced CIOs for institutional investors rose 5.8% to $1.96 trillion in the year ended March 31.
The pandemic could have a knock-on effect in the already fast growth of OCIO as asset owners take a close look at their portfolios in the wake of 2020’s market volatility. According to data from Pensions & Investments’ annual survey of OCIO managers, worldwide OCIO assets under management with full or partial discretion rose 5.8% to $1.96 trillion in the year ended March 31, 2020. Over the five-year period ended March 31, 2020, growth of worldwide OCIO AUM run with full or partial discretion was up 51.1%.
More than a market crisis
Turner said that the ballast provided by good governance is especially important now because this crisis is different from the global financial crisis of 2008: this time around, many organizations are experiencing what he called “mission impairment.” This isn’t just a market crisis, it’s an economic crisis that threatens their very viability.
“Clients are overwhelmed in so many other areas that it falls to the OCIO partner to help them stay focused and not get distracted by short-term noise that could destroy value over the longer term,” he said. “Because the real loss of capital occurs when people capitulate to short-term pressure at the worst possible time.”
“One of the most critical objectives of an OCIO is really expectations management,” said Jeffrey Palma, managing director and head of public investments, global fiduciary solutions, at State Street Global Advisors. “That means having a high level of clarity around roles and responsibilities, and always being able to anchor back to the core tenets of your portfolio construction and strategic asset allocation approach.”
That up-front work guides an OCIO and provides for transparent decision making. What is the client’s core objective: Meeting a return target? Derisking a pension plan? Meeting a long-term glidepath? Minimizing cash contributions? Each unique objective can dictate a unique course of action for the OCIO, especially important in a crisis, but always relevant to long-term strategic portfolio management.
“When we build portfolios, we want to be extremely transparent with clients about what we're trying to achieve,” Palma said.
“That’s important always, not just in a crisis. Even in relatively stable markets, as time passes and a cycle matures, it can be easy to lose sight of where the risks are. But with good governance, the client has appropriate expectations about what’s supposed to happen under what market conditions. It helps everyone view the portfolio not through the lens of what’s happening in the moment, but how things are going relative to long-term expectations.”
Adaptability: Executing in Challenging Times
Of course, strong governance doesn't mean being inflexible, according to Palma. He pointed out that, over most of 2020, OCIOs had to strike a balance between holding firm to clients’ investment policy statements and overall client objective, while also knowing when it’s prudent to adapt.
“If you consider how hospitals have been impacted by the pandemic, their long-term objectives still might make an awful lot of sense,” he said. “But in the throes of a financial squeeze like the one they have been seeing, the demand for liquidity, for example, might shift from the original underlying fundamentals and assumptions. There might be a need for levels of liquidity that in a normal market might not be a problem. In situations like this, it’s the OCIO’s job to work with the client to adapt. Here that might mean, on a short-term basis, tapping into longer-term assets meant to serve another role in the portfolio, like return or risk management.”
“We’ve done probably more tactical investing in the past nine months than in the last several years,” said PFM’s Link. “I don't think the strategic elements of the investing program were ever particularly stressed. No matter how bad it got, I think we and our clients always felt that we’d come out the other side at some point. But clients were definitely concerned about risk management, especially in late February 2020 and on into March and April.”
In a crisis, he said, clients aren’t as much worried about the return on their money as they are about the return of their money. So, while hewing to the strategic view is typically best over the long haul, he said, his team has been much more tactical in the short term to help conserve client capital.
“It’s hard to say how long that trend will continue, but throughout this challenging time, we have become more active as an allocator,” Link said.
“Being nimble is certainly very important,” said Rob Cittadini, managing director for institutional sales, Americas, at Russell Investments. “An OCIO partner needs the latitude to dynamically manage a portfolio, to manage risk or to seek opportunities, depending on the client's perspective and objectives.”
Cittadini pointed to March as an example: There wasn’t just an equity sell-off; other market shifts happened as well. On the fixed-income side, more illiquid bonds suffered from a great deal of stress, and there was significant divergence between the performance of U.S. Treasuries and credit instruments. In particular, high-yield spreads jumped from very low levels to very high levels and became very attractive within the month. But that spread widening has since slowly come back in again over time.
“The OCIO partner is always acting within the key guide rails established by the client,” Cittadini said, “but with a dynamic ability to adjust the asset allocation when required for a number of reasons, whether it's risk management or taking advantage of an opportunity caused by a market dislocation.”
“One often needs to act quickly because market dislocations can lead to opportunity; we saw some opportunities right off the bat, some of which existed for a very short time,” said Heather Myers, partner and non-profit solutions leader at Aon. “At the same time, we were very cognizant of risks. In principle we’re strong believers in rebalancing, but in the heat of the March drawdown, equity liquidity was strained. So we weren’t necessarily rebalancing portfolios all the way back to clients’ target equity weights right away. One has to strike a careful balance between being opportunistic and being risk aware.”
She added that being nimble also means handling individual clients differently, owing to their unique objectives and constraints.
“How we were working with defined benefit clients wasn’t exactly the same as how we were managing a healthcare operating fund or higher-ed endowment,” Myers said. “Even in a crisis, the specific objectives of each asset owner and asset pool are paramount.”
Relationships Built on Strong Communication
In a crisis, rapid investment execution can also put stress on communication processes and infrastructure. As external partners, OCIO providers have had to work seamlessly with internal client teams to get them the right kind of information, the right way, at the right time, all while clients were sometimes overwhelmed just trying to keep their heads above water managing their business.
“From our perspective, the OCIO’s lead client service person needs to be viewed by the client as their internal CIO,” said Russell Investments’ Cittadini. “That’s not a simple task, and it demands a level of trust that’s not built through a singular meeting. Instead, it’s built through continuous communication, open dialogue and transparency in good times and bad, keeping a focus on the long-term strategic goal.”
If anything, last year’s challenges proved that such a level of trust and steadiness cannot be forged in a crisis, firing off client communications out of the blue, particularly when clients face “mission impairment” and venues for in-person communication suddenly disappear.
“The last thing the client wants in that kind of situation is for the OCIO partner to make their life more complicated,” Cittadini said. “So the OCIO partner’s job, particularly around communications, is to keep the client focused on what they are trying to achieve. Make it simple, clear and relevant, and do your best keep them on the strategic path.”
“As things heated up in February and March, one critical communications element was just providing a holistic view to clients about what was going on. Beyond that, we needed to identify the most important topics for various types of clients and provide different avenues for accessing that information,” said Aon’s Myers.
She said that in a properly structured OCIO relationship, during a crisis there shouldn’t be a lot of back and forth between the OCIO and client in terms of agreeing on investment decisions. Just as it creates risk, crisis can create opportunity, and Myers said that where they saw opportunity and guidelines allowed, Aon took advantage.
“If the relationship is well documented and the investment policy statement properly written, we know what we’re supposed to do,” she said. “What needs to be communicated, then, is what we’re doing on the client’s behalf, that the situation is under control and that we’re focused on the long-term objective and policy targets that have been delegated to us.”
“In any time of crisis, quiet periods are dangerous,” said Thomas Kennelly III, managing director and senior investment strategist, global fiduciary solutions, at State Street. “As an extension of the client’s internal staff, the OCIO has to keep a clear head and communicate what’s going on in the market, their views around it, and where they think the market may be heading. And while that information has to be delivered proactively, it can’t be done in a way that creates a burden on the client.”
Kennelly said that the pace of communication picked up considerably as State Street worked with clients to address issues like portfolio exposures, cash reserves, risk mitigation, funded status, etc. But by and large, he said, State Street’s infrastructure held up very well, even as most communication moved quickly to remote or online channels.
“The key is to distill information and make it understandable and actionable,” he said, “staying focused on what’s most important from a policy perspective, making sure the client doesn’t miss the forest for the trees.”
“If you take good governance as a starting point, it’s that collaboration up front that ensures [that] when you act in the moment, and communicate that to the client, it’s not a surprise,” said PFM’s Link. “They will understand what you did and why you did it.”
Until mid-February, Link said that PFM’s portfolios had been overweight equities, but as the firm’s portfolio managers started hearing rumblings in the market they took that risk down. By the end of February, the word COVID was everywhere and the firm lowered its equity risk more. By mid-March, with a better handle on the implications of the pandemic on capital markets, the firm began dialing equity risk back up.
“At each decision point, we had a communication out to the client within a couple of days at most,” he said. “Clients expect that there won’t be much lag time: No ambiguity and no silence, with multiple venues for delivering information. So they can get it how and when they want it.”
Lesson in Discretion
“This past year has highlighted the fact that if you’re going to hire an OCIO, that firm needs to have enough latitude to actually execute the process,” Link said. “With many clients, given the way most of our client policy statements are written, we experienced as much as a 30% swing just in the domestic equity piece of the portfolio. We went from 110% of target to 80% of target in many portfolios between January and March  because of the risk environment, and I believe that was to our clients’ benefit.”
“The downdraft was severe and widespread across asset classes, but only lasted between four and six weeks, depending on how you measure,” said Palma at State Street. “Clients that hadn’t delegated discretion to their OCIO had almost no ability to effectuate real portfolio allocation change. Anybody on a quarterly update cycle with the investment committee likely missed any opportunity to try to take advantage of those dislocations.”
On the other hand, according to PFM’s Link, organizations that covet the investment process over other potential responsibilities will have a hard time with an OCIO relationship because they won’t delegate enough of the fiduciary duty to make it valuable. “When we get asked ‘What level of fiduciary duty should we give up?’ we would say that it's not really giving anything up,” Link said. “It’s delegating a part of the fiduciary duty to a partner who will listen, understand your challenges and then create a facility for solving those problems.”
And for Link, an important part of the OCIO’s fiduciary duty concerns accurate representation of performance using global investment performance standards, or GIPS.
“GIPS creates a verifiable track record designed to include all live client portfolios, not model portfolios, and not cherry-picked individual clients,” he said. “If an asset owner isn’t looking for verifiable documentation of performance, they’re leaving a stone unturned. That’s why GIPS was created.”
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“Anybody considering an OCIO model should not confuse delegation with losing transparency,” said Kennelly of State Street. “A good OCIO relationship is a partnership, not merely transactional. In many cases, just because we have delegation and full fiduciary authority, that doesn’t mean we’re doing things without communicating to the client, often in advance.”
“In an OCIO relationship, clients are essentially reducing the number of decisions they have to make,” said Cittadini of Russell Investments. “The aim is to be really clear about who owns which decisions and reduce down to a very small number of decisions. The most impactful and important strategic decisions may be owned by the client with the OCIO partner focused on the day-to-day judgment calls.”
Indeed, Russell Investments’ Turner said he is seeing increased levels of delegation in the realm of day-to-day judgment calls.
“Over time, one of the trends we’ve been seeing is more of a willingness to allow dynamism in client portfolios, even if it’s just within rebalancing ranges,” Turner said. “The OCIO partner can lose nimbleness if they have to go to the client, explain an opportunity, and then wait for approval to do something. You want that delegation established up front with transparent parameters for decision making, and we’re finding that more and more clients are willing to go that route because they have neither the time nor the internal resources for daily portfolio supervision.”
“OCIO models have become more flexible than they were a decade ago, or even five years ago,” said Aon’s Myers. “Investment committees that may have been somewhat reticent to letting go of some of their responsibilities are appreciating that they can find a workable solution from an OCIO perspective.”
“With greater education, clients are showing more acceptance and a steady movement toward giving the OCIO provider more discretion,” added State Street’s Kennelly. “That might mean more discretion around simple asset allocation and rebalancing triggers, or discretion around more complex triggers like pension derisking. Client preferences continue to evolve.”
“However, it still needs to be driven home to organizations thinking about OCIO that as an investment committee or as an organizational executive, you want to retain as few responsibilities as possible,” said Aon’s Ward.
He cautioned that waiting for an approval or veto from the client can muddy the investment process and prevent the OCIO from acting at a critical moment ― a sub-optimal structure that, when the client needs it most, very likely won’t work.
“They shouldn’t strive to retain discretion just because they feel like they’re giving up control,” he said. “Investors are still facing a period of significant uncertainty for at least the next six to nine months. Should additional crises arise, portfolio management may likely be the last thing on their minds.”
Emerging from Crisis: Where OCIO Is Heading
Coming out of a challenging year like 2020, existing and potentially new OCIO clients are taking a hard look at the capabilities required to deliver on broad mandates.
“One thing we have seen is that clients interested in discretion are starting to have a more stringent set of requirements around the OCIO’s capabilities,” said Cittadini at Russell Investments. “It’s no longer enough to provide great strategic advice, or even strategic advice coupled with investment management. The demand we’re seeing now, the further you move up that discretionary spectrum, is what I call the three-legged stool of sound strategic advice and investment management brought to life by a robust suite of implementation capabilities and resources.”
As part of the due diligence process, prospective and existing clients are also digging deeper into the decision-making processes that support investment implementation.
“This latest challenge hasn’t changed the underpinnings of the decision-making process, but I do think it has changed the pace of those decisions,” said PFM’s Link. “And clients regularly ask about how decisions get made. How do you decide on manager changes? How do you decide on a strategic allocation change? Investment professionals have to consume a lot of information quickly. And while they don’t have to act on every piece of information, they have to process that information and decide whether it should lead to a change. Clients want to know exactly how that happens.”
“I don’t think it’s appreciated how much asset management expertise an OCIO needs to be effective in their role,” Myers at Aon said. “Those considering an OCIO should take the time to probe and understand those capabilities. How do you come up with your capital market assumptions? What strategies do you look at? How do you model them? How are you stress testing? Having the expertise to create asset liability models, for example, then find the right managers and create an actual portfolio takes deep resources and a comprehensive skill set.”
As it gets harder and harder to find alpha, and tail risk keeps rearing its head, State Street’s Kennelly said he sees a demand for more sophistication in the OCIO’s repertoire.
“A lot of the conversations we’re having involve educating clients on ways to balance risk and growth,” he said. “That might mean equity risk management with smart beta or derivatives, or looking at capital efficiency and fixed income. Treasury futures, for example, can give you that duration but also allow some exposure to credit. We’re also helping clients get a better sense of a role for derivatives, especially how to incorporate risk monitoring and metrics around [them]. So there’s a new level 2.0, or 3.0, where you’re not trying to over-engineer portfolios and come up with a silver bullet per se, but instead enable clients to find new ways of getting growth exposure, but maybe a little bit more defensively.”
Part and parcel of the discussion around expertise is the question of how it’s applied to the specific clients and their unique objectives, according to Aon’s Ward.
“Being able to invest across a multitude of portfolios and objectives with different needs will likely be the biggest change the OCIO industry will see as more investor types adopt OCIO, including defined contribution plans,” Ward said.
Case study: DC plan emphasizes clarity over choice
In a word, the trend is toward greater and greater customization.
“The confluence of technology, human capital and client demand is all coming together to point in the direction of customization,” Cittadini said. “For example, the rapidly growing discipline of ESG comes together in different ways for different clients. I do not believe the client ecosystem will accept mass-market solutions that aren’t tailored to their needs, especially as demand moves up market to larger and larger clients. Holistic outsourcing and customization go hand-in-hand.”