How to evaluate a defined benefit OCIO provider
September 18, 2019
Outsourced chief investment officers, or OCIOs, are a service model where a pension plan sponsor or other institutional investor delegates certain decision-making responsibilities to a third party OCIO provider. Once the asset owner makes the original delegation, the OCIO implements, monitors and executes the investment and risk management strategies, within agreed upon parameters.
Here are five areas to consider when evaluating an OCIO: the range and quality of services, investment approach and flexibility, investment performance, fees and organizational stability.
The range and quality of services
In an OCIO relationship, each asset owner will normally retain high level strategic decisions. Beyond this, they delegate a range of ongoing functions to the OCIO. The range of delegated decisions normally includes some, or all of the following: selection, monitoring and replacement of managers; monitoring of investment performance; implementation and transition; tracking and execution of risk management strategies; rebalancing and cashflow management; and reporting and compliance.
In most cases the OCIO will utilize in-house capabilities to deliver these services. However, for speciality capabilities, like transition management, they may further outsource the function to another party.
For DB pension plans, the bundle of services could also include valuations, asset mix studies, regulatory filings and pension administration.
When evaluating the capabilities of an OCIO, it is important to first identify the bundle of service necessary for the target level of delegation and determine how each potential OCIO can satisfy the required functions in the mandate. It is then important to assess the quality of those capabilities. For example, if you are looking for an OCIO provider to manage the asset mix, consistent with the liability structure, you might lean towards a consulting firm OCIO, that may draw upon large globally integrated asset liability modelling and risk management teams and tools.
Investment approach and flexibility
Assessing the investment capabilities of an OCIO will focus on the following key elements:
Available Funds – Most OCIO providers will offer a range of internally built and maintained multi-manager funds. Assessing these funds involves an assessment of the quality the underlying mandates and internal manager research and portfolio construction capabilities of the OCIO.
At the same time the range of funds must also be considered. Generally, the more assets under management in the program, the more latitude the OCIO will have to offer more funds, which, in turn, allows their clients to build more tailored portfolios.
Alternative Asset Classes – Institutional investors are increasingly seeking greater portfolio exposure to alternative asset classes, which can enhance the risk return trade-offs achievable through a portfolio of traditional stocks and bonds. Again, scale may enable the OCIO to offer greater flexibility in alternative exposures.
Newer OCIO programs may limit alternative exposure to liquid alternatives or exchange-traded funds. As well, some OCIOs funds offer exposure to alternatives through a single diversified fund. Some will also allow larger more sophisticated asset owners to customize their exposure, based on their unique liability characteristics.
External versus internal managers – Some OCIOs, run by investment management firms, utilize internal funds on their platforms. While there is no inherent problem with the utilization of proprietary funds within an OCIO platform, some would argue that this structure may create pressure to increase the internal fund exposure, despite the fact that the firm might not excel in all asset classes. It may also be more challenging for an OCIO provider to monitor and replace internal funds on their platform, due the negative signals that such decisions could send to the market.
Passive mandates – Many OCIO funds will utilize passive funds or exchange traded funds as a way to gain exposure to certain asset classes. In some asset classes, such as US large cap stocks or Canadian universe bonds, where managers have had difficulties in consistently adding value relative to the benchmark and covering their fees, passive solutions may sometimes be favoured. However, exposure to passive options will limit the value-added potential of the investment structure.
The composition of multi-manager funds will vary from provider to provider, creating challenges in comparing the relative performance of these funds across OCIOs. Accordingly, it is important to evaluate these funds against their own benchmarks. If the benchmark is constructed properly, it will enable you to assess the impact of active management.
At the same time, the underlying mandates within each fund will change over time, as may the number of funds and style tilts and capitalization biases. Given the fluidity of these funds, an effective way to project future success is to assess the track record of the OCIO manager research teams in assessing their buy-rated managers in key asset classes. Many OCIOs track and report the aggregate value-added performance of their buy-rated fund picks.
While investment performance is a factor that must be considered, for some plan sponsors, portfolio performance may be a secondary consideration. For example, for a pension plan sponsor employing a de-risking solution, achieving the appropriate exposures and limiting the risk exposure may be more important than the value-added achieved.
The evaluation of performance should also assess the risk characteristics of the funds: How volatile are the funds? And, what is the tracking error of the funds — are they too diversified or benchmark oriented?
Generally, OCIO fees are charged as a percentage of assets under management. They are layered on top of the underlying investment management fee negotiated with the investment managers in the funds. In some cases, the breakdown between the OCIO provider and the fund managers are disclosed. In others, the total fee is provided.
While scale will allow large OCIO providers to negotiate better fees with their investment managers, what remains most relevant is how the aggregate fee compares to other competing offerings. At the same time, anticipated added value of selected managers can significantly outweigh minor differences in manager fees. If the plan sponsor is retaining some of their own existing managers within the structure, the OCIO manager spread on the assets becomes more important to assess.
The assessment of fees must also consider the bundle of services provided by the OCIO provider. It is critical that you are undertaking an apples-to-apples bundle of services in the fee quotes.
It is also important to assess the stability of the OCIO and its commitment to the business. This would include assessing management’s commitment to properly resourcing and growing the business and the stability of key personnel. Having strong asset flows is also important, as it allow greater investment in people and technology, as well as the scale to negotiate better fees. Asset growth also facilitates the enhancement and flexibility of the fund offerings.
Overall, taking a structured approach to evaluating OCIOs, by assessing these five factors, will provide a deeper understanding of the differences in OCIO offerings and help institutional investors make prudent selection decisions.