What happened? An insomniac’s guide to OCIO
I spent a 20-year stint as a former chief investment officer (CIO) at a large publicly-traded California utility company, and some days were better than others, but I never had to guide my plan through a global pandemic.
Even in normal times, managing a large pension portfolio was a challenging job. I was expected to have the answers to any questions around our defined benefit and defined contribution plans. I was helping to secure the retirement of my colleagues—and in many cases the majority of their life savings. I felt responsible for US$20 billion in assets—including a US$12 billion defined-benefit plan trust—and by definition, keeping track of that number of zeros comes with a few sleepless nights, even during calm markets.
What helped me sleep?
My team and I certainly did some things right. I felt pretty confident that the strategic investment policy we developed was on-point. It proved to be so. Which is good, because I'd estimate that the overwhelming majority of a corporate pension plan's investment program success or failure can be traced back to its strategic asset allocation and liability hedging strategy. Strategic asset allocation is high impact, but it's low frequency. If you do it right, it doesn't change all that often.
What made me lie awake?
On the other hand, my day-to-day charge as CIO was to put the best money managers together and generate positive excess returns. So I worked with a stream of top consultants to identify and hire the best managers. I then combined these managers in a way that I thought controlled risk and was destined to produce attractive active management results. Sounds simple. But to be frank, it was really a lot harder than it seemed even when markets were calm. When major market events hit—like the dotcom bubble bursting in 2000 or the Global Financial Crisis in 2008, it proved to be downright terrifying. Thank goodness I never had to go through COVID-19 as a CIO.
What just happened?
Finding and combining the best managers on my own meant one terrifying truth: Coordination across managers was limited. No one expected manager A to have any visibility into or responsibility for understanding anything in manager B's portfolio. If their combined exposures created common active-management biases such as high volatility or beta and momentum, that was my responsibility. I always knew that. But I didn't understand how poorly equipped I was to meet that challenge—until the hard questions came at the hardest possible times.
When volatility struck and the Chief Financial Officer asked about our exposures—about what we owned and what it was worth—it was a tough question to answer because my aggregate manager view was limited. The review cycle occurred no more often than once a quarter and even then it wasn't a live view. It was decidedly backward-looking.
Keep in mind that all this stress occurred in the face of substantial resources—a skilled internal team, outside consultants, custodians, and more. I honestly thought I was taking a best-in-class approach. But if that was the case, why was I still lying awake at night worrying about the next market shift?
Until I moved to this side of the desk—and began working for one of the largest OCIO providers—I didn't realise that there was a pretty logical way of re-engineering this process. It was then that I finally recognised that the best outsourcing providers had already done the work.
OCIO provides visibility.
A key need I had was enough visibility to truly manage managers. I needed to know exactly what risks I held in my portfolio, how those risks aggregated, and the impacts of those aggregations. How does OCIO solve this? World-class OCIO providers come with risk-management platforms. Ideally, the platform is security-based, updated daily and able to provide actionable information. Instead of the CIO trying to mine for answers, the OCIO provider's portfolio management team provides clear visibility into the holdings of client portfolios. At Russell Investments, our team knows precisely what our OCIO clients own at any given time and stands ready to share that in a prepared report.
OCIO helps to navigate the storm.
In 2008, most of us CIOs saw our equities crater, causing asset allocations to move outside of allowed ranges. We all had to deal with the question of rebalancing. For those of us without OCIO in place, rebalancing decisions were often subject to committee approval and discussion. The problem is that investment committees are composed of human beings and this "let's discuss it" process can often cause fear to impede or delay a rebalancing decision that was designed in calmer times to ensure a specific risk budget was maintained. We all have that fight-or-flight reaction when faced with an uncomfortable situation. Even for rebalancing, where the strategy is intellectually compelling, heart rates can still increase when a planned-for risk becomes palpable. On the savannah, this fear may trigger a run for the unmistakable safety of the Jeep. In falling markets, cash can often appear like the refuge of the Jeep, but in reality, the perception of safety is illusory and can severely impair your chance for recovery. In this admittedly-fractured analogy, the Jeep is actually the strategic asset allocation. Staring down the fear and reverting to the planned strategy represents the best option for recovery.
So, how can we take some of the emotion out of the rebalancing process? For our OCIO clients, we reduce the impact of emotion by assuming rebalancing responsibilities and documenting the key parameters in our clients' investment policies. For these clients, it would be rare not to execute according to the policy. But in choppy markets, our objective is to do so in the most cost-effective way possible. Minimising transaction costs requires a world-class trading capability, but also requires traders with decades of experience. As my colleague Jason Lenzo recently reminded us, traders who brag about having 10 years of experience have never traded in a bear market prior to 2020. It's vital for your OCIO partner to know through experience what it costs to move money in normal markets as well as what you are up against when moving money in stressed markets.
In addition to rebalancing, many corporate defined benefit portfolios' liability-driven investment (LDI) strategies could benefit by moving beyond hedging strategies that are myopically focused on fixed income to take a total portfolio approach. When you pull up to the plan level, you may quickly realise that although corporate bonds may do a nice job of mirroring the discount rate, their spread component is highly correlated to equities. When things go bad, stocks decline and spreads widen. Including an allocation to Treasures provides both capital efficient duration as well as downside risk management. Our OCIO solution is designed to improve many aspects of the investment program and includes the daily risk management required to ensure that this LDI 2.0 is properly positioned every day to meet the portfolio sponsor's hedging objectives. And believe me, our clients were happy they had some Treasury exposure in the first quarter of 2020.
What are you doing now in response?
In late 2008, I was working to just get through the financial crisis. In 2009, my team and I intentionally took a breath and paused for reflection. We asked ourselves, What could we have done better? So I challenge you, as an institutional investor, to take a breath and ask yourself: What went right? What could have gone better? In what areas could I have used more specific expertise, harnessed more resources or both?
For organisations that have the right level of resources, the right level of sophistication, the right level of vision and the strength of will, it may be possible to meet investment objectives with a predominantly in-house tool set. And we stand ready to assist those teams in any way we can.
But for others who see the potential of this more robust approach, I staunchly believe OCIO is a solution worth exploring. This isn't to say that OCIO is the right fit for everyone. But how will you know if you don't take the prudent step of going through an evaluation? Isn't it worth learning more about the potential, asking the hard questions and running the numbers? Wouldn't it be reassuring to your CFO and other leaders to know that you took that proactive step? If you can't conclude that the value proposition is real at the end of the process, at least due diligence has been done. And that step alone may help eliminate a sleepless night or two.