Nearly all CFOs and investment committees consider it. And more than ever are acting upon it: investigating the possibility of an Outsourced CIO (OCIO) to manage their institution’s investments.
When assessing potential OCIO providers, institutions typically first cover two “essential Ps”—the providers’ People and Processes. But once that due diligence is completed, and the evaluation process enters the final stretch (that is, the waning pages of an RFP), it comes down to two more Ps that are just as critical: Performance and Price. And this is where the reporting can get a little muddy.
The reason: While OCIO providers’ people and processes are relatively easy to compare and contrast to determine their value, performance and price are areas where such simple and direct comparisons are more difficult to make. Neither of these categories lends itself to a simple check-the-box activity. Rather, drawing comparisons is a complex apples-to-oranges exercise, because there are so many variables to consider in each of those categories.
Complex, but not impossible: Here are some criteria for comparing the price and performance of OCIO candidates.
One size fits all?
Given the multiple variables involved in assembling an institution’s investment portfolio, there really is only one simple way that a direct comparison could be made of OCIO performance—that is if portfolio construction were of the one-size-fits-all variety, in which all institutions invest in the same vehicles in the same percentages.
Some OCIOs do indeed employ this “single fund provider” model. The vast majority of OCIOs, however, go the other way, employing a customized approach to assembling a portfolio for each of its institutional clients. They tailor asset allocation to the individual organization’s unique investment policy, objectives and strategy. In this customized portfolio realm, direct performance comparisons are not only nearly impossible to draw, but also—given the inconsistencies in construction—virtually meaningless to attempt.
The challenge in determining an OCIO’s performance begins with the question of how exactly one wishes to define the term. Is performance return? Is it return within a given risk profile? Is it risk-adjusted?
The fact is, today there is no standardized way to define performance. And if it cannot be singularly and consistently defined, how can it be measured and compared to other providers?
Consider that the OCIO process begins with understanding the purpose of the institution and its fund(s), which leads to a desired set of risk/return guidelines that govern portfolio construction. Under this process, performance is simply an outcome. And, by definition, performance outcomes are as unique as the institutions themselves and should not be compared casually.
Let’s back up for a moment and recognize that the reason there is no such thing as a standard definition of performance is that there is no such thing as a standard portfolio construction. After all, the components and allocation of a portfolio are unique to an organization’s requirements, its investment policies and objectives, and other considerations. So, if organization A’s needs and mandates dictate a more conservative portfolio mix, and organization B’s needs and mandates dictate a more aggressive allocation, the performance of those portfolios should not be compared.
Peel that onion a little further, and one uncovers still more variables. Consider, for example, an institution’s investment mandate. An endowment may establish, say, a 4.5 percent real (i.e., after inflation and fees) return benchmark, while a foundation may establish one of 5.5 percent real. Two different types of institutions, two different goals, two different portfolios.
Another layer: An institution may dictate constraints and prohibitions on its investments (for instance, no hedge funds, no tobacco, no alcohol, etc.), while another may not. Again, two sets of rules that result in two different portfolios.
Given the above differences in portfolio construction, attempting to compare performance is like trying to keep score of a game in which the teams are playing on two different fields.
Tips for comparing OCIO performance
Intent on attempting a side-by-side comparison of OCIO performance? Consider these tips.
- Ask all OCIOs to show the percentage of their clients that beat their custom benchmarks, after fees, over standardized time periods (e.g., 1, 3, 5 and 10 years).
- Always ask for net, not gross, returns; similarly, always ask for actual, not back-tested, performance.
- Be sure OCIOs include all client portfolio results, rather than a cherry-picked few, in their historical performance.
- Get a breakdown of OCIOs’ historical average return by institution size, as well as by asset class as seen in this example from the most recent NACUBO-Commonfund Study of Endowments (NCSE):
Many institutions conducting an OCIO search will claim price doesn’t matter. But everyone knows that it does. And the fact that it doesn’t appear until the last few pages of an RFP belies the weight that fees ultimately carry in the decision-making process. Fees are rarely noted in surveys as being among the most important criteria in OCIO selection, but committee decisions often cite cost as a key deciding factor.
It’s a simple enough question: “What are your fees?” The answer isn’t quite so simple, or even as quantitative. In fact, when asked what it costs to manage their portfolios, few institutions can actually cite a hard and fast number.
OCIO fees are determined by many of the same client considerations that drive performance differences: client type and size; investment committee mandates and objectives; governance models; and investment strategies and asset allocations. For example, active (vs. passive) management and/or investing in separate accounts, commingled funds or partnerships, may increase fees. And institutions may be willing to pay more for OCIOs’ fiduciary responsibility and operational expertise.
Fees vs. costs
One challenge in determining total outlay for investment management is, frankly, defining one’s terms, as in fees paid vs. total costs. In a recent Commonfund survey, most institutions could only offer estimates of their investment management costs—ranging from 64 to 80 bp.
However, those numbers failed to account for ancillary fees such as custody, legal and other costs (see the sidebar above). Once those are factored in, the actual total cost easily exceeds 100 bp and can approach 170 bp.
Extending this concept into the OCIO realm, a key factor that makes fee comparisons challenging is that, often, institutions evaluating OCIOs confuse fees paid with total costs. When an institution asks an OCIO “What are your fees?” and the response is, say, 35 basis points, some investment committees may be taken somewhat aback—especially when the number is compared with a consultant’s typical base fee of 10 basis points plus travel.
Again, though, just as in the performance realm, it’s an apples-and-oranges comparison. And when a few important considerations are taken into account, institutions typically find that the “10 vs. 35” comparison is an invalid measure.
Note that an institution pays all these external fees whether they use a consultant or an OCIO. If one were to list out consultants’ and OCIOs’ fees in similar fashion, their respective total costs would actually be quite similar.
An important step to take, then, in evaluating and comparing fees is to separate the OCIO’s own fee from other underlying charges. (Note: An OCIO that values transparency will be able to parse fees for you.) Only when that is accomplished can an institution accurately measure and compare fees.
Another important consideration in comparing fees is understanding an OCIO’s additional duties and resulting value.
Let’s say that an OCIO offers more than just investment advice, and expands its expertise to more holistic financial guidance. That OCIO should be viewed as providing sizable added value and be compensated accordingly. In addition, if that OCIO provides back-office duties (which, incidentally, consultants generally do not provide), a higher fee is similarly warranted. Also, if the OCIO is taking on the responsibilities of an in-house, full-time employee(s)—reconciling books, managing cap calls/distributions, etc.—it’s important to account for the cost savings of that employee(s) in fee calculations and comparisons.
Different fee models
A third important consideration in comparing fees is the same lack of standardization found in performance metrics. There are several different types of fee models in the OCIO realm, and it’s important to peel the onion (again) in order to decipher them. Among the options: “flat fee” and the “flat-fee-plus-incentive/carry.”
While the flat fee model is self-explanatory, the flat-fee-plus-incentive/carry model entails a number of variables that muddy the comparison waters. Among those variables: benchmarks, time frames (over what time frame will the incentive be calculated?), and percentage of “clawback,” or fees refunded due to unique circumstances.
The flat-fee-plus-incentive/carry model has proven to be controversial over the years. Some institutions embrace it, believing that it incents higher performance from their OCIOs. Other institutions are more sanguine, contending that a fee-plus-incentive structure incentivizes the OCIO to take greater, potentially inappropriate risks in pursuit of the benchmarks that earn them performance bonuses.
In evaluating OCIOs, keep in mind that assessing performance is not a simple check-the-box exercise.
Not just checking boxes
At first blush, performance and price may seem straightforward and quantitative measures. But they are far from simple matrices. In evaluating OCIOs, keep in mind that assessing performance and fees is not a check-the-box exercise. History has shown that it actually takes more time and effort to decipher these two seemingly quantitative categories than the qualitative ones such as people and processes.
The CFO and investment committee need to consider and understand fees and performance in the right way, in both upfront selection process and on an ongoing basis, in order to make a prudent OCIO selection.
In evaluating OCIOs, keep in mind that assessing performance is not a simple check-the-box exercise.