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Decoding the OCIO Black Box: Trust but Verify

By Sanjoy Chatterjee, Chief Strategy Officer, Investment Metrics

The outsourced chief investment officer (OCIO) model has thrived in recent years and continues to be a source of rapid growth for investment consultants and major asset managers alike, as more institutional investors seek help with asset allocation, manager selection, managing liabilities/spending policy, ESG and allocation to alternative asset classes. A recent report estimates growth of the OCIO market at 5 percent annually for the next three years.

OCIOs have operated with some opacity, being transparent about investment performance, risk, and attribution, but holding onto many of the fine details behind these outputs – functioning in a ‘black box’ manner not unlike that of traditional asset allocator advisory practices.

As the total portfolio outsourcing trend to OCIO’s evolve the need for more objective transparency will increase. As OCIO competition heats up, asset owners are digging into the connections between fees, manager selection, portfolio rebalancing and performance, to see if they’re getting best risk adjusted performance to meet their respective investment goals. Asset owners are also asking for more data and insights about allocations to alternatives sleeves and overall ESG exposure to support their overall fiduciary responsibilities.

Quite simply, OCIOs will have to adapt their operational models. Performance and proclaimed diversification are no longer enough of a differentiator, especially in a crowded market. In the forthcoming year, asset owners will be more willing to partner with OCIOs that value transparency – and shed those relationships where the details in appropriate disclosure, data & insights are lacking.

A question of fees 

Asset owners want more insight on fees – both the fees that asset managers charge OCIOs and the wrap fees that OCIOs charge the asset owners, and whether they are justified across the various asset classes.

Because OCIOs manage investments on behalf of multiple institutions, they have the leverage of pooling assets to negotiate better investment management fees with asset managers with the intent of passing on the benefit of better diversification at a reasonable cost for all asset owners. Fee structures will also vary across these managers, depending on a number of factors, like investment strategy/ asset class and investment vehicle.

This level of detail isn’t always communicated to the asset owner. Thus, the institution may not be able to factor this data into the absolute return for the investment sleeve, manager or the total portfolio, making it hard to determine whether the overall performance justifies the fee.

Asset owners need this data – not just to weed out underperforming managers, but also to rationalize allocations towards high-fee yet high-performing managers to their investment committee. A recent analysis of active manager fees, performance, and the efficacy of institutional fee negotiations by Investment Metrics found that top-quartile funds, namely in large-cap domestic growth and global equity funds, delivered performance that were relatively commensurate with their higher fees, while underperforming value funds did not. Similarly, the fee structures for alternative assets can be quite complex and confusing since they consist of multiple levers linked to either absolute or relative performance thus providing options for OCIO’s to simplify the same as part of their offering to their asset owners.

Guidance for changes to the risk profile

Another reason that asset owners are leaning more heavily into their OCIOs for transparency: the asset classes that they’re investing in are becoming complex.

It’s well known that institutions have upped their allocations to alternative assets with longer-term investment horizons and lockups. OCIOs are well versed in this market, with a depth of research, information, and networks that asset owners rely on. 

Indeed, one of the drivers behind the rapid growth of OCIOs is their ability to help asset owners navigate the intricacies of these often-challenging asset classes. This is especially true as private market investments continue to increase with the promise of them being non-correlated assets providing better long-term yield.

Yet, for asset owners making these sorts of changes to the risk profile requires a great deal of transparency, strategic direction, and compelling data. Long-term liabilities have to be balanced with shorter-term liquidity requirements. Fiduciary requirements trigger deeper compliance and due diligence requirements for investing in alternative asset classes. Investment committees are more closely scrutinizing alternative asset class allocation decisions, fees and investment structures, no matter how promising the returns. 

Thus, OCIOs will be pressed even harder for detailed reporting – not just in its granularity, but also in its frequency. Daily reporting, namely for more complex or illiquid instruments, will become more common using consistent asset class proxy methodology. Overall portfolio changes by active managers will have to be communicated closer to real time, to provide a more accurate picture of risk. 

Investment decisions will no longer occur in a vacuum. OCIOs will need to provide their clients the same level of insight that the asset owners themselves would expect if they were making the allocation decisions themselves.

Data and due diligence

As the OCIO competitive landscape is evolving, asset owners have become more thorough in their OCIO selection process.

Top-level return, portfolio and operational data will no longer suffice. Institutions want to know exactly the details of the asset allocation to managers within the OCIO’s asset class sleeves and their absolute and relative over/under performance, including the factors that have driven that performance. Third-party data and analytics around factors, peer comparison and industry performance have become more widely available, making it easier for asset owners to determine whether OCIOs have truly added value through asset allocation and manager selection, or whether outperformance is more market driven. With the similarities between various OCIO strategies continuing to increase, transparency into the ‘whys’ behind their performance becomes advantageous. 

Transparency in the selection and due diligence process will need to go beyond investment returns. Asset owners and consultants want to know more about the operational processes that underpin investment selection. In other words – how are OCIOs sourcing and managing data, what kind of data are they getting from the managers themselves, how rigorous is their analysis and how does it drive the investment process?

Asset owners will prefer to partner with OCIOs that have a disciplined investment ‘secret sauce.’ But that doesn’t mean that they’ll say yes without knowing what’s in it.  

Decoding the black box

Overall, the mission of an OCIO is take on the fiduciary responsibility of the total assets by leveraging their internal research to structure the portfolios asset allocation and manager selection to meet the respective short term and long-term investment goals of an asset owner while providing the benefits of asset class diversification at a reasonable cost. The above mission resonates with most Institutional investors leading them to trust the OCIOs they work with. Additionally, the asset owner benefits from not having to staff up an internal investment team for the day-to-day operations of their investments. 

Yet, we see this notion of trust being replaced with the adage “trust, but verify.” Asset owners want to be sure that their OCIOs are delivering on their promises and instill confidence with their investment committees. With so many investment options out there, asset owners need the data & insights to justify that they’re making the right decision.

In this context, OCIOs will find it increasingly difficult to operate with opacity. Increasing the level of operational transparency based upon the evolution of the growing OCIO market will create a true differentiation for OCIO’s to capture market share based upon the future growth. For astute OCIOs, this creates the opportunity to show off their prowess and create competitive distance from peers that are all too eager to take the mandate off their hands.