Confessions of a former CIO, Part 2: Aren’t you already outsourced?

Summary:

• Most defined benefit plans are already outsourcing their investment programs—it's just a matter of degree.
• Additional productivity benefits may be available by harnessing even more external resources.
• Three potential benefits of expanded outsourcing can be improved returns, reduced risk and lower costs.

It's the question on every CIO's mind these days: What's up with outsourcing and should you be threatened or excited about it?

Answer: It's really a moot question because you're likely already outsourced —perhaps without even realizing it. Take it from me, a former chief investment officer (CIO).

Even the largest internal investment management teams harness external resources. For example:

• Few internally manage trust and custody. Why? Scale.
• Few internally trade derivatives. Why? Complexity, technology, risk management and underwriting expertise.
• Few transition assets internally. Why? Inability to manage market risk while assets are in flight.

I assert that a better question is actually how did I decide to outsource the stuff that I have and why did I stop there?

Let me explain. As a CIO at a publicly-traded California utility company, my organization chart showed that I only had a staff of two people. But my team had an annual budget of $36 million. And, no, my team and I didn't each earn $12 million a year.

So, where did all the money go? Truth be told, the overwhelming majority of my budget was spent on a virtual org chart—a network of external resources marshalled by my team, with the objective of effectively managing the company's defined-benefit (DB) plan.

In other words, this sizable chunk of money—30 basis points of the utility's $12 billion portfolio—was earned by outside entities. Put more bluntly, it went to outsourcing.

Now, in my days as CIO, I never would have used that word to describe our approach. But looking back, investment outsourcing is exactly what I was doing. Whether it was retaining consultants to perform asset/liability modeling and help me identify high-quality investment products, contracting with specialists to assist with transition management, or hiring asset managers to select and trade stocks and bonds, I was clearly delegating portions of my company's investment program to an external staff. The bottom line was this outsourcing was a heavily-used strategy to enhance the productivity of my limited internal resources.

With this came the gargantuan task of herding scores of individuals across the globe toward one common goal: meeting the objectives of my company's investment program. In essence, I was the boss of a virtual network of extended resources—my outsourcing partners—working on investment-related tasks that were quite distinct from the core business of the public utility company.

Many of the specific investment capabilities needed to wisely invest our employee benefit plan assets simply weren't accessible in-house. Why? For the simple reason that my company wasn't a money manager or an asset consultant or a transition manager. Yet individuals with these skillsets were critical to achieving the objectives of our company's investment program. In a nutshell, this is why so much of my budget went to hiring—and consequently, managing—outside expertise. Outsourcing.

This situation is all-too familiar in the CIO world. Your own internal org chart may show that you only manage a small staff while your actual management duties are tenfold. Any CIO knows that their company's organizational chart typically reflects only a small portion of their oversight responsibilities. And between us, we know that this is one reason the complexity of our jobs is sometimes underappreciated. You're the glue that holds the company's entire investment management operation together, a managerial task that is completely understated when measured by your internal headcount or budget.

All this is to say that the world of outsourcing is anything but black and white. Just because externally delegated work isn't classified as outsourced on paper doesn't mean it hasn't been outsourced. In reality, when it comes to investment outsourcing, the landscape is awash in shades of gray.

50 shades of outsourcing gray

I've been around the investment business a long time—on both sides of the desk. For 20 years, I was a CIO. But for the past six, I've helped to steer Russell Investments' Outsourced Chief Investment Officer (OCIO) services program. With three decades of experience as an investment professional, I can firmly say this: No company or organization, public or private, runs its entire investment program in-house.

Every CIO outsources something. It's just a matter of degree.

Now, it's not hard to see why many organizations have decided to outsource much of my prior function as a CIO. With internal resources becoming increasingly stretched across the corporate landscape, many organizations have done their due diligence and calculated the potential savings that tilting to a more outsourced model can deliver. In addition, the growing need for risk management and the increasing complexity of markets and regulations, coupled with the shrinking profile of defined-benefit pension plans as part of the company's employment package, are reasons often cited by companies who choose to outsource the vast majority of their investment program.

At the other end of the spectrum, others firm choose to pursue a more selective strategy. Some are outsourcing only the trust and accounting work while carrying out portfolio management duties in-house. Others are exclusively externally managed or employ a more discriminating, case-by-case philosophy such as hiring transition-management specialists or fund-of-fund alternatives managers. But there is virtuous angle even for these organizations to the expanding outsourcing wave. As more OCIO firms face the same challenges as internal CIOs, their capabilities are broadening the menu of services available to the latter on a more selective basis.

My key point here is that investment outsourcing isn't an if. It's a how much and to whom? That is: To what degree should a CIO be outsourcing the company's investment program? Is there room to create more efficient and productive programs by increasing the use of external resources?

The three tenets of improving investment productivity: Improved returns, reduced risk and lower costs

Over my years as a CIO, I learned there was incredible value in simplicity when pitching portfolio management ideas to investment committees. In that same spirit, my pitch to you is that I believe a CIO's job boils down to doing some combination of three things: Increasing returns, reducing risk and lowering costs.

INCREASE RETURN
Designed to aggregate small gains and minimize losses

REDUCE RISK
Designed to measure, monitor, and manage risks throughout the portfolio

LOWER COSTS
Designed to reduce unnecessary and unrewarded costs

As we all know, the financial industry can be very creative in developing strategies to drive toward these objectives. For example, the chart below lays out the platform that supports Russell Investments' OCIO deliverables and are available a la carte to the institutional investing community:

The constraint usually isn't a lack of potential ideas but rather creating the bandwidth to harness them. This is why I firmly believe that every CIO needs to ask whether or not they're getting enough out of the company's current investment outsourcing model:

• Are there ways to potentially extend your outsourcing network to increase the effectiveness of your investment program or reduce costs?
• Are there more tricks to the OCIO trade that you're unaware of and might borrow?
• Short of full outsourcing, what more can an OCIO firm do for your organization?

In my view, it's well worth the time to consider expanding your productivity by leaning in further to outsourcing and harnessing more external resources. Here are a few ideas:

• Lowering risk levels for well-funded plans

It's critical for well-funded retirement plans to lock down their surplus risk—in other words, to de-risk. With this comes the need for specialists that can ensure that the plan's asset/liability risk is truly being lowered to safer levels.

Well-funded plans typically need help measuring this risk at a granular level to ensure that the plan doesn't fall out of its fully funded status. Yet the sophisticated risk analytics required to do this—and allow a CIO to sleep at night—are often too specialized or expensive to bring in-house. What's the answer? Retaining an outsourced provider to manage this on behalf of the plan.

• Reducing interest rate risk and improving returns for underfunded plans

For corporate retirement plans that are underfunded, there's often a tug-of-war between the need for growth and the need for a higher interest-rate hedge ratio. In these instances, growth assets (i.e., equities) are needed to close the plan's funding gap. Yet these growth assets often compete on a dollar-for-dollar basis with assets designed to hedge the impact of falling interest rates. How can your finite asset pool work harder to more effectively manage these dual objectives?

This is where a skilled OCIO provider can take charge. For instance, one solution to this dilemma is to maintain growth assets in the plan while simultaneously achieving a higher hedge ratio. This is also known as capital efficiency. In short, capital-efficient strategies can be accomplished by working with an OCIO provider to either hold longer bonds or employ derivatives overlays to extend the duration of these bonds. Without reducing the plan's growth profile, a higher interest-rate hedge ratio can be achieved to more effectively manage the risk of falling yields.

• Navigating the risks of late-cycle investing for all plans

The seemingly never-ending U.S. equity bull market, now in its tenth year, is the longest in American history¹. While most plans have benefited from the significant rise in asset prices, we've noted an increasing worry among plan sponsors today that their risk exposure may be too high and they're not adequately positioned for the inevitable market downturn. Risk management, understandably, has since become an increasing priority for many companies.

Investment outsourcing can lend a helping hand here as well. A skilled OCIO provider can offer a basket of solutions to manage a plan's risk level. These strategies include using options to provide downside protection or deploying dynamic risk management, smart beta and factor exposures to ensure the portfolio's risk exposures are appropriate for the market environment and intentional, rather than a byproduct of manager structure.

The bottom line

I know I've been banging the outsourcing drum for a while. And I also know you've probably heard from countless individuals touting its potential benefits. Some of them are probably my colleagues. To be clear, I'm not saying you need to pull the plug on your in-house investment program and go all-in on OCIO. One size doesn't fit all in investment management, much less in deciding the degree of outsourced investment management. Very few programs are at one extreme or the other. Most can be characterized as a judicious mix of internal and external resources.

But for CIOs that are already in the business of outsourcing some of their investment capabilities … and that's really all of you … I contend it's only logical to further explore how another look at outsourcing can help to improve the productivity of your internal resources and meet more of your investment objectives.

Read Part 1 of the Confessions of a former CIO