Confessions of a former CIO…on OCIO
- By delegating discretion to multiple external parties, most corporate pension plans have been outsourcing for years, but many have not considered a comprehensive OCIO solution.
- Our OCIO solution represents a strong value proposition: delivery of more robust and effective investing programs at a lower cost—even for large pools of capital.
- OCIO won't work for every asset owner, but it seems prudent that fiduciaries at least explore the possibility.
"You don't know what you don't know"
During my 20-year stint as a former chief investment officer (CIO) at a large publicly-traded California utility company, I thought I had the best job around. Although I wasn't directly involved in delivering gas and electric services to customers, I was helping to secure the retirement of my colleagues that did, lending a certain nobility and heft to my small team's mission. Running a corporate pension plan portfolio is also a pretty specialized task. That meant I could play an expert role on the topic of financial security in the eyes of senior management and my peers. And finally, because I was responsible for $20 billion in assets (including a $12 billion defined-benefit plan trust), I got to meet the best and brightest minds in the investment industry. I was an in-demand customer—everyone wanted our business. Somehow, my jokes were always funnier at work when I was being pitched by a money manager than they ever were at home.
But early in my new Outsourced Chief Investment Officer (OCIO) role, I was reminded of one of my grandmother's favorite observations: Remember, you don't know what you don't know.
This simple saying has rung in my ears at several key points in my life. And it has applied in spades as I have transitioned from being an asset owner to helping clients achieve their objectives as part of team delivering OCIO solutions. This simple change in perspective has resulted in aha moments that have been both confirming and revelatory about what I had accomplished in my former role.
On the gratifying side of the ledger, the strategic investment policy we developed has proved to be on-point. 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. With the best advice available, I believe I got this right for my investment committee, plan participants and the company.
But honestly, when it came to selecting and combining money managers, there was a problem—one that I didn't perceive at the time. You see, while setting overall strategy was a low frequency/high impact activity, my day-to-day charge as CIO was to put the best money managers together and generate positive excess returns. To do this, 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 delivered attractive active management results. Sounds simple. But to be frank, it was really a lot harder than it seemed. And when patience with mixed results became strained, giving up on active management was viewed as the only alternative. That was what I knew.
Then I moved to the other side of the desk and joined an asset management firm. Enter my epiphany moment—the realization that there was something I didn't know I didn't know. That while manager selection and allocation were necessary, they weren't sufficient. Another model had emerged that I hadn't considered, in part because I thought my approach was state-of-the-art and my asset pool was too big.
The OCIO value proposition: Investing more effectively—and at a lower cost
In my corporate role, I observed how executives made decisions. Even for very complex and weighty choices, they tended to gravitate toward business cases that could be simplified to their essence. In that spirit, the OCIO proposition can be thought of as a straightforward value proposition: Investment outsourcing holds the promise of more reliable and effective business results delivered at a lower price point.
Improving the investment process
In retrospect, I thought of my process solely in manager chunks, but coordination across managers was limited. That function certainly wasn't being handled by the managers. After all, manager A had no visibility into or responsibility for understanding anything in manager B's portfolio, nor the profile of their combined exposures which can collectively exhibit common active management biases such as high volatility or beta and momentum. I always knew that was my job, but I didn't understand how poorly equipped I was to meet that challenge. The result was a limited view of aggregate manager exposures, a review cycle that occurred no more frequently than quarterly and was decidedly backward-looking. Structural adjustments were infrequent and limited to changing managers or how assets were allocated among them.
What I've learned is there's a pretty logical way of re-engineering this process. But it does take investment in resources and tools as well as adoption of a lens focused on aggregate exposures. It can be summarized in three steps:
- Understanding what you truly own. This goes back to having adequate visibility to truly manage managers. It seems obvious, but you have to know exactly what risks you hold in your portfolio and how they aggregate across the manager chunks.
What does this take? Investment in a risk management platform that is ideally security-based, updated daily and able to provide actionable information. In my new role, I work with a portfolio management team that has clear visibility into the holdings of our clients' portfolios. They know precisely what our OCIO clients own at any given time.
- Having a forward-looking view. So now you know what you own. Great. What do you do with this information? Conceptually it's simple: The objective is to reduce or completely offset risk factors you don't believe will be rewarded and periodically enhance exposures where you see opportunity. The trick is to ensure factor exposures are aligned with your strategic investment beliefs while preserving the value added by underlying managers' security selection decisions.
- An implementation toolkit that extends beyond investment manager selection and allocation. Once you have a good understanding of the risks you own and the risks you want to own, how do you bridge the gap? I would argue that the more nuanced view of managing risk exposures that emerges from the first two steps above requires a more surgical toolkit to augment manager-level decisions.
Access to both synthetic and physical factor-management strategies becomes integral to controlling risk exposures. By working at an OCIO firm that has developed these competencies internally, I've found that we can precisely control our OCIO clients' risks and position them to best meet their desired outcomes with dexterity.
Now, OCIO isn't the only way to make this process walk and talk. In fact, there are asset owners who are making the commitment to people and systems to evolve their internally-resourced investment programs along these lines. And some of these firms have partnered with us to access key dimensions of our risk management system and insights while harnessing our implementation platform to precisely deliver their targeted exposures.
But this level of commitment was beyond what I could have contemplated marshaling in my former role. True asset management as described above was too dissimilar to the broader mission of the company. It is difficult to envision competing for the resources necessary to make this happen. But at an OCIO firm, it's a completely different story. OCIO is core to our business—it's what we live and breathe. Making these resource commitments is totally aligned with our fundamental mission. And personally, I can focus on helping our clients achieve their fiduciary goals by partnering with hundreds of investment professionals who are similarly dedicated to this mission. The importance of that alignment can't be overstated.
Economies of scale: What I thought I had, I really didn't
In my CIO days, I thought I had strong buying power. After all, I was responsible for managing $12 billion in defined-benefit plan assets. Surely this made me an 800-pound gorilla in the eyes of potential investment managers, right?
Recent experience tells me I was wrong. At my current firm, we have $290 billion in assets under management (as of March 31, 2019). That's roughly 24 times more than the assets that I oversaw. In other words, it's a whole different level of buying power. And I have seen that buying power be applied to benefit asset pools of all sizes. A recent conversion of a $9 billion plan to OCIO resulted in overall fee savings of over 20%, including the OCIO cost.
The P word: Might it be prudent to explore OCIO?
There's no question this approach I've described is more ambitious and requires thinking innovatively about implementation. But knowing what I know now, I personally would have a hard time stepping back into a process where I was responsible for managing risk without a more fully developed process like the one I've described. Once you've seen the power that having the right tools and resources brings to investing, you can't un-see it.
For organizations 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 an 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 go through an evaluation? Isn't it worth learning more about the potential, asking the hard questions and running the numbers? If you can't conclude that the value proposition is real at the end of the process, at least due diligence has been done. You may well find out you know that OCIO isn't the right answer for your fiduciaries. I believe there's real prudence in reaching that conclusion.
The bottom line
Now, I'll be the first to admit this sounds self-serving. But after having walked both sides of this street, I genuinely believe that the OCIO value proposition has matured to the point where consideration just seems to be the responsible thing for most fiduciaries to do.
Take it from me, a former CIO, who knows now what I didn't know then.
Related link: Learn about Outsourced CIO for institutional investors here.