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Investments
Institute
May 2013
Research
Introduction
As investors reach for returns in a sometimes bruising market, they are adding private equity, hedge funds,
and other alternatives, leading to increasingly sophisticatedand complicatedportfolio monitoring and
management. Heightened regulatory and compliance requirements have further increased the time and
resources required to meet fiduciary responsibilities. This has led some investors to consider delegating
investment oversight, monitoring, and management duties.
The industry press regularly reports on a large and rapidly growing outsourced chief investment officer
(OCIO) market, and some fund sponsors wonder if this model would serve them better than the traditional
consulting model. Funds managed through an OCIO are beholden to the same challenging market environment and regulatory atmosphere, but the burden of balancing these challenges can be largely shifted from
the investment committee to the OCIO provider. Some funds find this solution meets their needs.
In this paper, we explain the OCIO model, describe its value, and provide a series of questions to help
fund sponsors contemplate whether outsourcing might be appropriate for them. We also compare Callans
traditional consulting model to our outsourcing approach.
Overview
Definition and Demand
In the OCIO model (also known as implemented consulting, discretionary consulting, or delegated
consulting), an institution shifts discretionary authority to an advisory firm to manage some or all of the
investment process. These functions would normally be performed by the investment committee, potentially with a consultants help.
The increasing popularity of this model is a response to the frustration investment committees have felt
amid a disconcertingly unfamiliar environment in which returns are hard to come by, risk is elevated, and
a glut of new investment vehicles have inundated the market. These elements have created an exceptionally challenging landscape in which complications (unlike returns) are in ample supply.
For example, Exhibit 1 depicts the degree to which the task of realizing a 7.5% return has become substantially more problematic over the past 15 years. Using capital market assumptions from 1996, we see
that a portfolio seeking a 7.5% return could allocate the vast majority of its assets to fixed income. Contrast
that with 2012, when a portfolio seeking the same return had to be far more diverse, with more than 80%
of assets allocated to riskier asset classes.
Exhibit 1
Asset Allocations for
Projected 7.5% Return
Real Estate 7%
Non-U.S.
Equity 3%
Broad U.S.
Fixed Income
73%
Broad U.S.
Equity 34%
Source: Callan
Non-U.S.
Equity 22%
The modern-day investment backdrop has become more global and intricate. At the same time, the in-house
talent required to oversee these more complex portfolios, manage risk, and ensure compliance is becoming
more expensive, which is particularly daunting in light of the constraints being placed on institutional budgets.
Key factors that are driving institutional interest in the OCIO model include:
1. Highly unpredictable and multifaceted capital markets
2. Limited investor resources vs. rising costs associated with maintaining in-house resources
3. Little margin for error in a low-return environment
4. Demand for expertise in uncorrelated assets, particularly alternative investments
5. Difficulty gaining exposure to best-in-class managers
6. Heightened attention on liabilities (for defined benefit plans)
7. Challenges in fulfilling fiduciary obligations given the presence of greater scrutiny and regulation
8. The proliferation of new financial instruments that must be vetted for their applicability
Interest in OCIO can be partially attributed to concerted marketing efforts deployed by actuarial and investment consulting firms, asset management firms, and start-ups (often created by former CIOs of large
institutional capital pools). All of these groups stand to benefit from the transfer of investment authority
from a diverse population of investment committees to a more concentrated group of professional entities
focused on the deployment of an OCIO business model.
Market Size and Scope
Estimates as to the size of the OCIO market vary widely, in part because the industry has yet to consistently define these relationships. Hence, identifying them is problematic. For example, strategic consulting
firm Casey Quirk recently estimated the 2012 OCIO market was $298 billion and projected it will grow to
$500 billion by 2016 (a compounded annual growth rate of 15%).1 Another firm, Spence Johnson, identified the market at $881 billion and projects growth to $1.5 trillion by 2015.2
It is difficult to say which of these figures is accurate, or if both are drastically overstated. Callan finds
that fund sponsors often decide to stay with traditional consulting when they learn certain functions
pertaining to fiduciary responsibility and liability cannot be delegated. Based on this, Callan feels the
ultimate adoption of OCIO may fall short of some industry analysts predictions.
Small-to-mid-sized corporate defined benefit plans, other private funds, endowments, and foundations
are most likely to see the potential applicability of an OCIO model because these groups have fewer resources and stand to benefit from the economies it brings to the table.
Some larger plans have also seen value from an OCIO model; however, Callan has experienced very
limited interest from this group to date. We attribute this to the simple fact that larger organizations tend to
have the resources necessary to manage complexity and compliance issues in-house.
While they cannot change a funds capital market expectations, OCIO providers are likely able to devote
more time, be more flexible, and move more quickly than an investment committee that meets intermittently. Also, the OCIO provider may be more consistent than a committee, which can change portfolio
strategies along with membership seats. Maintaining an arms length means the OCIO provider should
have the objectivity to move the portfolio only when there is a need to do so.
Fiduciary Responsibility
An OCIO firm may become a 3(38) fiduciarya reference to ERISA section 3(38)in that the fund sponsor
effectively delegates the significant fiduciary responsibilities and liabilities of investment selection, monitoring, and replacement. When the OCIO organization has the discretion to make decisions for the fund, it also
takes over the legal culpability for those decisions from the fund sponsor, which can be attractive.
Giving discretionary authority to an OCIO firm that accepts fiduciary accountability for its investment decisions relieves the investment committee of this responsibility. However, this does not release the committee from its fiduciary responsibility for selection and oversight of the OCIO firm. The fund sponsor must still
set goals and objectives for the fund, and clearly communicate them to the OCIO provider. These remaining fiduciary responsibilities lead many fund sponsors to revisit the practicality of an OCIO arrangement.
Whereas in a traditional model the fund sponsor may focus on granular details, the responsibility changes
to strategic oversight and vendor management in an OCIO model. The role of the fund sponsor in an OCIO
arrangement does not disappear; rather, it simply changes to something different but equally essential.
Callans traditional and OCIO processes are quite similar, save for a few subtleties as depicted in Exhibit 2.
Exhibit 2
Sample Comparison
of Traditional vs. OCIO
Consulting
Traditional Consulting
OCIO Consulting
Investment Committee/Board
Investment Committee/Board
Investment Committee/Board
Investment Committee/Board
Investment Committee/Board
Callan
Staff
Callan
Staff
Callan
Ongoing Operational
Management (rebalancing, fee
Staff
Callan
Callan
Callan
Performance
Measurement
Callan
Callan
Non-Delegable
Investment Decisions
Determine Strategic Asset
Allocation or Investment
Structure
Investment Structure;
Manager Selection,
Monitoring, and Termination
Operational Actions/
Implementation
Ongoing Support
Source: Callan
In the example depicted in Exhibit 2, Callan has been asked by the fund sponsor to take on all of the
investment committees decision-making responsibilities, including asset allocation, investment structure,
manager hiring and firing, and fee negotiations. We are also responsible for opening, funding, and rebalancing accounts. (This is not indicative of all OCIO arrangements, as in certain circumstances Callan is
asked to assume only some of these responsibilities.)
The primary difference between the two models is the way in which decisions are made. In the OCIO
model, Callan actually serves as the client investment committee. At the outset, we form an in-house
investment committee on the clients behalf. This committee consists of team members from our Fund
Sponsor Consulting and Trust Advisory Groups, as well as additional specialists when appropriate. The
committee is responsible for all aspects of the fiduciary process. It has full discretionary authority, meets
regularly, and votes formally on all investment decisions. Callan is responsible for implementing all decisions made by the committee.
In exchange for a higher level of fiduciary and operational responsibility, we charge a higher fee for OCIO
consulting than our traditional model. However, this increase can often be offset for the investor through
fee reductions we negotiate with the investment managers, custodians, and recordkeepers employed in
the implementation of the asset allocation.
Investment portfolios created under the OCIO model may look slightly different than those of Callans
traditional consulting clients given the unique OCIO environment. To illustrate, we next present two case
studies revealing how OCIO implementation varies depending on the investors needs.
Exhibit 3
Investment Style
Private Foundation
Asset Allocation
Fixed Income
30%
15.0%
15.0%
Absolute Return
9%
Hedge Fund-of-Funds
3.0%
3.0%
GTAA
3.0%
Real Estate
10%
Core Property
4.0%
3.0%
Income
3.0%
U.S. Equity
25%
5.0%
7.5%
5.0%
2.5%
2.5%
2.5%
Non-U.S. Equity
20%
8.0%
6.0%
3.0%
3.0%
Private Equity
Target Allocation
6%
Secondaries
6.0%
Total
100%
Tier I
Asset Allocation Options
Tier II
Core Options
Tier III
Specialty Options
Capital Preservation
Money Market
Fixed Income
Real Assets/TIPS
Risk Spectrum
Active Short-Term
Active Core Plus
International Equity
DC Three-Tiered
Fund Lineup
Less
Exhibit 4
Self-Directed Brokerage
Account (SDBA)
Conclusion
OCIO involves the outsourcing of investment oversight, monitoring, and management to independent
experts. Institutional investors that cannot afford the substantial in-house resources required to manage
the modern portfolio might consider implementing the OCIO model. However, OCIO is not a one-sizefits-all solution, nor a panacea for a challenging, low-return market environment.
The OCIO market will grow in the coming years, though the magnitude of the expansion may not meet
the high expectations set by some in the industry. Callan has thus far seen the greatest interest in this
model from small-to-mid-sized private funds, endowments, and foundations. Funds that are looking to
outsource their investment process will have the most success if they pursue a customized, high-quality
approach with an OCIO provider that recognizes their funds unique characteristics and carefully incorporates them into implementation.
10
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