The outsourced chief investment officer model comes into its own

KEY TAKEAWAYS

• Outsourced CIO role is more popular as margins squeezed
• Enhancing investment outcomes and risk management are key drivers
• Due diligence is a must when choosing a third-party provider

Outsourcing is not a new concept in asset owner circles. Handing over back- and middle-office tasks to a third-party provider is commonplace, especially for small to medium-sized firms that do not have the deepest of pockets. However, squeezed margins and intense competition have even forced larger institutional asset owners, including pension schemes, to examine every aspect of their business model.

The challenges of the past four years have been well documented. Asset owners, family offices, financial advisory firms and wealth managers have not only had to grapple with a difficult macroeconomic environment but market volatility, geopolitical tensions and regulatory burdens. In addition, many are adding a range of more complicated alternative assets, such as private equity and infrastructure, to give their portfolios an extra boost.

As a result, the once unthinkable idea of an outsourced chief investment officer (OCIO) is increasingly becoming a reality for many, according to a report by bfinance. Although services can be tailored, packages typically consist of policy design, governance, environment, social and governance (ESG), manager research, portfolio management, and middle and back-office functions. The latter covers risk management, communications, and reporting.

It is not just the minnows that are taking the plunge. For example, in the UK, BAE Systems’ GBP 23bn defined benefit pension scheme is one of the latest to make the move. It follows in the path of other weighty peers, including the Royal Mail Pension Plan, Centrica Pension Scheme and the National Grid Pension Scheme, to name a few. The beneficiaries for those four were Goldman Sachs Asset Management, BlackRock, Schroders and Russell Investment respectively.

In the US, where the OCIO model has been a feature for several years, the bfinance report points to Cerulli research, which shows that assets under management are expected to surge from USD 2.4trn at the end of 2021 to USD 3trn by 2026.

Reasons to go down the OCIO path

There are many drivers but the main ones for 71% of the 1,400 institutional investors canvassed in a report by Coalition Greenwich are to enhance their investment acumen and gain access to a broader array of investment strategies as well as managers. This reflects an overall strategic shift toward leveraging specialized knowledge and resources to improve portfolio diversification and tap into unique market opportunities.

The report also found that around 55% wanted to generate better risk-adjusted returns by employing an outsourced chief investment officer’s skill in asset allocation and manager selection, while 45% were looking to build and implement customized risk-management strategies. This was to help mitigate market turmoil and safeguard the portfolio against downside risk.

The lines between their services can seem blurred with other popular modes of outsourcing such as fiduciary manager, the multi-asset pooled fund and the multi-asset fund of funds. A closer look by bfinance reveals key differentiators. The most notable ones are an OCIO will typically provide an investor with greater control over investment policy and asset allocation as well as rely more on external asset managers than their fiduciary colleagues. However, both will tend to offer a higher level of support on non-investment services than a multi-asset pooled fund or a multi-asset fund of funds. This is beginning to change, with some multi-asset managers stepping onto their territory, positioning themselves as a potentially economical alternative to a classic OCIO construct for a smaller investor.

There are regional differences, but the Coalition Greenwich report revealed that only 11% of global investors currently use an OCIO to manage a substantial portion of their portfolio. The preferred option is to allocate the entirety of their ‘plan assets’ to their OCIO provider. The approach to giving discretion over these assets—whether full or partial—is more marked. In Europe, there’s a prevailing practice of granting only partial discretion to OCIOs, while North American and UK investors tend to allow full responsibility, entrusting them with complete authority over investment choices.

Wise choices and mandate implications

Whatever route chosen careful due diligence is a perquisite, as it is with selecting any third-party providers. There are over 100 firms who can offer this service, but their depth and breadth will vary. Scale seems to matter which explains why the top 10 OCIOs dominate, managing over half of all the assets. They are all global household names who have other business lines in asset management and consultancy, according to the bfinance report.

Finding the right match is important. The checklist should include experience, technology prowess, costs, partnership philosophy and any potential conflicts of interest such as direct or indirect linkages with either internal products or certain external asset managers. As the report notes, there may be some positive side-effects of using internal products, such as potential fee savings, but it is crucial to have a very clear division of services, teams, management and incentivization.

As far as smaller asset management firms are concerned, OCIO hires can result in fewer mandates being available because of the consultants’ aggregation of assets.

‘Some smaller asset management firms will be unable to accept the large mandates awarded by OCIO providers; others will be excluded from consideration by OCIO providers who mitigate risk by avoiding awarding mandates that would constitute a relatively large share of an individual manager’s total AUM,’ Greenwich said.

Nevertheless, there is hope. OCIOs providers are constantly in search of innovative ideas they can use for their clients’ portfolios. So, whether large or small, those asset managers who punch above their weight and report above-market returns would be well-placed to win mandates.

Efficient internal operations are crucial for asset managers and owners trying to grow market shares and value, and outsourcing is undoubtedly on the rise as external pressures and complexities drive a change in business models. Choosing the right third-party technology and services provider is one of the biggest investment decisions asset managers can make. Trust and track record should be front and center in this decision because the price of getting it wrong will be great.