Introduction: No Overlooking Operational Capabilities
The use of an outsourced chief investment officer, or OCIO, is becoming increasingly popular. As a result, the OCIO industry is experiencing a dramatic increase in the volume of assets managed and the number of providers and clients.
While expertise in selecting the appropriate investment program and managers have become established core services, little attention is being paid to the equally vital task of determining the robustness of the operational functions—including people and technology—that support OCIO implementation and execution of the investment process. Failure to invest and establish required infrastructure to support these programs could result in operational errors with significant financial impact to not only the OCIO provider, but also the client’s portfolio. At NEPC, we believe there will be an increased focus on operational capabilities as it is critical to ensure the provider has the knowledge, capabilities and sound processes in place for the appropriate management of a client’s portfolio to minimize risk. We have a strong understanding of these requirements and possess the expertise, people and technology to be a trusted partner to our clients.Based on our experience, we outline in this paper some of our recommendations for best practices around an OCIO’s operational structure (Exhibit 1).
Outsourcing to a discretionary investment manager can help with the effective governance of investment programs. OCIO firms provide a wide range of products and services, including daily oversight of an investment program, allocating assets, and the work involved in hiring and terminating investment managers. OCIO assets are estimated to cross $1 trillion by the end of 2016 compared to nearly $91 billion in 2007, according to Chief Investment Officer’s 2016 Outsourced Chief Investment Officer Buyer’s Guide (Exhibit 2, on the following page). Another estimate from Charles Skorina and Co. puts total OCIO assets already at $1.3 trillion in 2016, up 19% from 2014. In addition, the number of new clients outsourcing to a discretionary investment manager increased by 2,189% over the last eight years to 10,903 in 2015 from 479 in 2007, according to CIO. The number of providers has also seen explosive growth. There were 71 providers as of 2016, according to Charles Skorina, up from 45 firms in 2012.
Still, there are certain functions that remain with the fiduciaries, including the responsibility of carefully hiring and monitoring the discretionary manager. Many OCIO providers and search firms have emerged from consulting firms or other advisory relationships where they have been making investment decisions for many years and, as a result, the related infrastructure exists and is robust. These core activities include portfolio management, manager research, monitoring due diligence, and reporting performance and exposures. The new and typically underdeveloped areas relating to the implementation of investment decisions include selecting the appropriate vehicle suitable for the client, managing the lifecycle of transactions, mapping liquidity, monitoring cash daily, reconciliations, and documenting the audit history of activities.
With this in mind, the resources supporting the OCIO model introduce operational risk. So, understanding an OCIO provider’s operational capabilities is vital to outsourcing success. At NEPC, we are confident we have the appropriate capabilities, and can guide clients through the requirements and recommended best practices for customized solutions.
OCIO providers vary by complexity and structure, and their service offerings are hard to compare. OCIO firms range from large consultants who have dedicated OCIO businesses, to registered investment advisors, investment management firms, and standalone OCIO providers. While it can be challenging to compare providers because there is no one-size-fits-all model, there are key characteristics that define a strong operational standard.
It is also important to understand the operational infrastructure that an OCIO provider has established in order to deliver services. These capabilities usually require a heavy emphasis on experts with operations and data knowledge, and technology infrastructure that is “real-time,” more so than what is typically available in an advisory relationship. These areas include a well-defined data governance model, and disaster recovery and system back-up plans to ensure little to no business disruption.
An OCIO acts as an extension of a client’s front and back office, and it is important it has the knowledge and understanding to act in that capacity. Often, an OCIO provider may only offer implementation services while the client maintains the investment decision. Depending on the OCIO model and the needs of the client, delegated responsibilities may be customized (Exhibit 3, on the following page). In this case, the level of understanding of how the OCIO will deliver and support these services is critical. Ensuring a provider has the infrastructure and processes in place to reduce operational risk should be a strong consideration in the evaluation process.
The Four Pillars of OCIO Operations
The following are the building blocks that lay the foundation of an OCIO provider’s operations structure:
The human capital supporting the operational components of the investment process can be considered an extension of the client’s administrative or treasury functions. These people are ultimately responsible for the successful implementation of an investment decision in a timely manner. These requirements can become increasingly complex for alternative asset classes. Clients may want to shorten the time between an investment decision and its implementation, and this can be achieved only with a highly-effective operational infrastructure.
Therefore, it is important to understand the background of the operations staff when evaluating OCIO firms. It is worth examining if there is a dedicated operations team. The consulting team and support staff should not provide the client’s back-office operations support.
Another issue to due, while ensuring all this happens in a timely manner. They also review data to make sure transactions are properly executed. While these details may not be at the forefront of a typical advisory consultant during the recommendation phase, professionals in the operations space focus on these items with exactness. Understanding operational processes is very different from working as an advisory consultant or asset manager. Operational details range from locking and storing wire instructions for each investment and custodian, to the daily monitoring of custodial cash, and differentiating investments by legal structure and suitability for the client.
(ii) Portfolio Monitoring
In an advisory relationship, consultants typically review client portfolios monthly with some consultants possessing the wherewithal to do so daily. That said, for an OCIO provider, gone are the days of relying on monthly monitoring of portfolios or monthly flash reports for investment decisions. It is vital for an OCIO provider to understand and have daily access to portfolio values. If there is significant market turmoil, the provider should be able to understand the portfolio positions and exposures on any given day and take action as needed. This is why it is essential to understand the tools used to monitor portfolios internally. A red flag should be raised if the provider relies solely on a custodial website or custodial data to make investment decisions. The OCIO provider should make a distinction between the Investment Book of Record (IBOR) and the custodian’s books and records. IBOR refers to the records maintained by the OCIO provider and reflects all the investment decisions made by the OCIO, regardless of the timing of a settlement. In contrast, the custodial books and records reflect activity recorded by the custodian and represent the portfolio’s accounting books and records. The timing of recording this data may be delayed or inaccurate and, therefore, it is critical that the OCIO provider maintain its own books and records to have a precise view of the portfolio at any point in time.
Given that many clients considering OCIO providers are longer-term investors, one may question the need for daily valuation and monitoring. As a best practice, we believe an OCIO provider should have a view of a client’s portfolio on any given day regardless of whether there is trading or not. This provides a basis for making sound trading decisions and paves the way for taking advantage of investment and rebalancing opportunities. It also allows a provider to take action as soon as it is warranted rather than waiting for a monthly reporting cycle, which could lead to a missed opportunity or increase risk in a client’s portfolio.
(iii) Custodial Data and Oversight
An OCIO provider acts as the investment fiduciary of a client’s portfolio and is entrusted with monitoring assets. The provider is also responsible for monitoring custodial activity and ensuring cash and related transactions are properly accounted for to minimize any potential losses as a result of error or fraud. The records from the custodian are ultimately reported in a client’s financial statement.
As we mentioned earlier, while the custodian maintains the accounting book of record for the client, the OCIO is responsible for the Investment Book of Record (IBOR). With the IBOR, the OCIO has a view of its investment decisions, regardless of the custodial data. This structure enables the OCIO to perform an independent reconciliation with custodial records. A potential red flag: when an OCIO relies solely on custodial data and uses a spreadsheet to manage a portfolio. While not insurmountable, the risk of error and potential missed data or investment is significantly higher when there aren’t such checks and balances and data is not secured. Managing this data becomes more complex as clients multiply. As a best practice, we believe cash and transactions should be reconciled daily. We recommend portfolio holdings be reconciled at least weekly.
A common issue with custodial data is that some custodians record only the investments held in custody, leaving clients with the need to track investments on their own and piece together reporting. This is a dated practice and we believe custodians should record all assets within the multi-asset class framework, including hedge funds and private equity investments. OCIO providers should have a strong understanding of custodians, their capabilities and competitive market fees to ensure they are getting the most value for the services being offered.
It can be challenging for an OCIO provider to oversee and service assets across a multi-asset spectrum. While robust tools exist for trading stocks and bonds and monitoring hedge fund or private equity investments, it is vital to bring these diverse asset classes together onto one consolidated platform in order to monitor portfolios. As the OCIO market continues to grow, a number of technology firms are looking to develop solutions. A few providers have emerged that fit well into the OCIO market, providing a platform within the multi-asset structure. The frequency, data requirements and level of oversight required by an OCIO provider are typically more involved than what a consultant would perform in an advisory relationship. As a result, the tools used by OCIO providers should be more robust. It is important to understand the technological capabilities of an OCIO during the selection process. Monitoring portfolios daily and efficiently implementing investment decisions are just some of the functions that are better achieved through the use of technology (Exhibit 4, on previous page). It is important to understand the operational capabilities of your current or prospective partner with so many new entrants to the OCIO industry. An inability to adequately invest in technology infrastructure should be a major red flag.
OCIOs are entrusted with sensitive client data and understanding how the data is stored, accessed and shared with external parties is important. As a best practice, access to data related to client accounts for trading purposes should be limited and changes should require authorization. This is especially relevant if the OCIO provider outsources back-office operations to technology providers. At the heart of any vigorous technology solution is a well thought-out data model with people and processes possessing the skills to execute and manage the applications. These form the structural foundation of a sound operating model.
Conclusion: Are You Convinced Yet?
As the OCIO landscape continues to expand with new entrants, it is vital to ensure the OCIO partner you choose has the operational expertise and staff to efficiently monitor and carry out your investment decisions. In addition, an OCIO provider should demonstrate expertise and have infrastructure to support the operational requirements of a client’s investment program. Settling for anything less could result in significant financial losses to the OCIO provider, as well as client portfolios.
How can NEPC Help?
NEPC has a strong understanding of our clients’ requirements. We also have the expertise, people and technology in place to be the trusted partner for our clients.We can guide clients through the OCIO process and educate them on the requirements and what we believe are best practices for customized solutions. Please contact NEPC at 617.374.1300 for more details.
Employee-owned NEPC, LLC is one of the industry’s largest independent, full-service investment consulting firms, serving over 300 retainer clients with total assets over $900 billion. Headquartered in Boston, Massachusetts, and with offices throughout the United States, we’re known for incisive expertise and exceptional service. And results: NEPC’s collective client base has outperformed the InvestorForce/ ICC median* in 25 of the 30 years since our founding in 1986.
* The median fund in the $3.4 trillion InvestorForce Universe (or the ICC Universe through 2011) represents average performance among a nationwide sample of plan sponsor results.
Disclaimers and Disclosures
- Past performance is no guarantee of future results.
- The information in this report has been obtained from sources NEPC believes to be reliable. While NEPC has exercised reasonable professional care in preparing this report, we cannot guarantee the accuracy of all source information contained within.
- The opinions presented herein represent the good faith views of NEPC as of the date of this report and are subject to change at any time.
- This report contains summary information regarding the investment management approaches described herein but is not a complete description of the investment objectives, portfolio management and research that supports these approaches. This analysis does not constitute a recommendation to implement any of the aforementioned approaches.