Once upon a time, say fifty years ago, it was common for bank trust departments to manage assets on behalf of nonprofit organizations and other asset owners.
The investment management business really hadn’t grown up yet. While there were some mutual fund companies and many brokerage firms, it was common for wealthy families to have their money managed by banks. They often had long-standing and multi-faceted relationships with the firms that had helped to finance and grow their businesses. The management of pools of money — such as pension plans and the funds of nonprofits that were the beneficiaries of their clients’ philanthropic interests — was another of the many services that the banks provided.
They were one-stop shops for managing those assets; in most cases a banks ran the entire investment portfolio, which was then comprised of blue-chip stocks and plain-vanilla bonds.
A variety of factors, including the adoption of ERISA in 1974 and an increased emphasis on performance comparisons, led to the growth of the institutional consulting industry. Soon asset owners of all kinds were selecting investment managers with ever-narrower specialties; custodial banks kept track of everything. Meanwhile, traditional balanced accounts started to fade away and the influence of bank trust departments in the institutional realm faded along with them.
This trend continued for decades, as portfolios became more complex and the number of managers exploded. Even with the help of consultants, it was hard for the members of investment committees to keep up with everything. Changing managers or adding a new strategy in the portfolio was a slow process. It might take discussions at one or two meetings before giving the consultant direction to do a manager search — and one or two more to make a selection, usually involving an in-person beauty contest as the final step. Assuming quarterly meetings, that’s half a year or more after the idea was first raised before the change was made.
A reversal of trend
Many investment committee members liked interacting with consultants and being involved in the selection of asset managers, but it was an inefficient process — and the readiness of the members to deal with their obligations varied widely.
Gradually (and then suddenly), all of that changed. Today, for those asset owners who aren’t big enough to field their own in-house staff, the de facto standard is the use of an outsourced chief investment officer (OCIO). An OCIO is today’s version of a one-stop shop, a firm that has the discretion to make all investment decisions within the parameters established in advance by the client. In that kind of arrangement, the investment committee’s role becomes one of governance and monitoring.
(In practice, the dividing lines can vary from situation to situation, and can be complicated by legacy holdings or relationships that give the OCIO something less than free rein over the whole portfolio, but the dividing line outlined above is the essence of the OCIO concept. As an illustration, a Russell Investments piece includes an appendix with a list of duties with “retain/delegate/partner” choices for an investment committee to consider.)
The players
As it became clear that the OCIO trend had legs, the investment industry did its thing. Everyone wanted to get into the business, and there are now entities calling themselves OCIOs with these historical roots: traditional consulting firms, investment banks, endowment fund spin-offs, family offices, asset managers, wealth management firms, and those bank trust departments. Plus, there are firms that were formed specifically as OCIO providers.
In addition, the OCIO model has been adopted by all different kinds of entities, including endowments, foundations, defined benefit pension plans, defined contribution plans, insurance companies, investment advisory firms, etc.
The name is an odd one. You’d think that an outsourced chief investment officer would be a person, when what you’re really getting is an outsourced investment function.
Some directories include the year that a firm started in the OCIO business. If one is listed as having been at it since 1979, for example, it probably was a bank trust department. The term “OCIO” and many of the services now offered came around much later on.
Maturation
Every OCIO provider offers marketing material explaining why the concept makes sense, usually grounded in the rationale that the complexity of markets + the speed of change + the need for access to the best asset managers on the planet = something that’s beyond the capabilities of a typical investment committee (so let us do it for you). Every market spasm has led to further adoption of the model.
While it started as a way for smaller asset owners to upgrade their approach, larger and larger pools of assets have gone the same way. Putting an exclamation point on the trend, BlackRock announced in June 2021 that it had been hired by British Airways for a £21.5 billion ($30.5 billion) OCIO mandate.
Evaluating OCIOs
Today, the OCIO industry looks different from what it did even a few years ago. Here are some considerations if you are hiring an OCIO, trying to evaluate your current one, or thinking about switching to another provider.
The business models. As mentioned above, OCIOs have come from all different parts of the ecosystem. Each of the business models presents potential conflicts, quite varied in nature, as a simple comparison of the length and content of their respective disclosures and regulatory filings indicates. Where the OCIO function fits within a firm and how it interacts with and draws upon other lines of business internally are important.
Capabilities. Beyond that, the historical roots of a firm have shaped its expertise, world view, processes, and culture. An OCIO that grew up as an institutional consultant providing advice will be different in its orientation and capabilities than a global investment bank (or a firm in any of the other categories). Each entity brings strengths and weaknesses simply because of its history.
Clients. Some OCIOs, by virtue of their roots or specific targeting strategies, have concentrations of certain types of clients. The mix of clients matters, since time horizons, standards of practice, and organizational concerns vary by asset owner type.
Range of services. OCIOs provide a range of services beyond investment management. An asset owner needs to think about which services are important — to make those retain/delegate/partner choices — and to evaluate how to weigh the capabilities of the investment management function versus everything else. For example, given how hard it is to generate alpha, helping a foundation or endowment to get (and maintain) a deep understanding of its financial situation and risks so that it can adopt a sustainable spending policy could be more consequential than a few basis points here or there.
Investments. A detailed look at the pure investment part of the equation is beyond the scope of this posting, but some of the broad categories to evaluate (in addition to the organizational and business model considerations) include: investment philosophy and beliefs; the investment team; the overall investment process; asset allocation; due diligence and manager selection; portfolio structure and implementation; and risk management. Each element is important and for every one there is both narrative and reality. Avoiding the allure of the former and discovering the latter is the essence of good due diligence.
Fees. Mixed in with the business model issue is the fact that fees can be hard to figure. One provider, Commonfund, summarizes the challenge this way:
Due to a lack of transparency and consistency across the industry, the “sticker price” for an investment manager is often misleading, resulting in many investors not knowing what their actual “all in” costs are, much less if they are paying a reasonable rate for each underlying component.
While an Institutional Investor article says:
For OCIO firms that are part of larger companies with custodian, brokerage, or investment management businesses, extra costs may arise when the OCIO division funnels assets through other lines of business.
Performance. Investment committees (and governing boards and other stakeholders) obsess over comparative performance, despite the fact that every asset owner is different and effort should be focused on finding the structure, strategy, and portfolio composition that meet its specific goals over a long time horizon. In essence, that’s what an OCIO is supposed to do. But a lack of comparability with other organizations is frustrating to many, so now there is an index (with sub-indexes) that track OCIO performance. It’s hard to argue with having more information with which to make decisions, but history demonstrates that the availability of such information mostly leads to short-sightedness and poor decision making.
OCIO search consultants. Not surprisingly, there are now scores of search consultants ready to help asset owners to parse the complexity and provide advice about the range of OCIO providers. (Disclosure: The editor of this site has acted in that capacity.) As with every other link in the principal-agent chain, the consultants bring the possibility of needed expertise (at a cost), but they come with their own business models, biases, and (often) an unwillingness to buck the tendency to overweight performance in the selection process, since that is the most obvious and easiest thing to sell.
Time horizon
Starting about three years after an OCIO has been selected, other providers will contact the asset owner and/or search consultant to see how things are going with the organization that was selected.
Granted, it’s possible that there isn’t an organizational fit and that the asset owner will want to make a change on that basis. But other OCIOs know that it’s likely that people will get itchy if performance isn’t what they think it should be. They are expecting asset owners to play the three-to-five year cycle that almost everyone has used when selecting and evaluating asset managers (and which has been shown in study after study to be counterproductive).
You should go into a relationship with an OCIO with a time horizon of a decade or more. These should be long-term affairs. That doesn’t mean that changes can’t be made before then, but having the proper mindset at the beginning provides the needed perspective for the selection process — and saves you from unnecessary hassle and cost by avoiding unwarranted performance concerns thereafter. If you did your homework on the OCIO up front and it is doing what you asked of it, there is no need to react to the short-term noise of performance, which flops back and forth over time.
It’s not as if you’ll magically find a better OCIO anyway. They are more alike than different, and if you select a new one that has had good performance you might become a client just in time to see that revert.
Plus, the costs of replacing an OCIO can be significant, especially if you have been investing in private assets. One search consultant, Alpha Capital Management, has laid out those issues in “OCIO 2.0? Don’t Forget Your Bags.”
Going deeper
Investment committees that employ an OCIO have the freedom to concentrate on the activities with the most impact rather than the trivial ones. The typical meeting fare (performance information, along with economic and market reviews and outlooks) doesn’t prepare you for your ultimate responsibilities — and all those pages and pages of details in the quarterly reports provide documentation but not enlightenment.
Instead, you should spend almost all of the available time in your meetings on education regarding:
The evolving dynamics as both your organization’s circumstances and market conditions change over the years, which may require asset allocation adjustments;
Topics where committee members don’t have the necessary experience to understand the implications of the risks the organization is taking; and
Going deeper into the OCIO’s organization and capabilities; otherwise, over time, the interactions become routine rather than revelatory — and your understanding of the firm narrows rather than broadens.
Then you will be prepared to make the big decisions when they need to be made.
Published: March 14, 2022
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