The Optimal Outsourced Chief Investment Officer

The Optimal Outsourced Chief Investment Officer
April 12, 2023 24 mins

The Optimal Outsourced Chief Investment Officer

The Optimal Outsourced Chief Investment Officer Hero Image

For institutional investors, engaging an outsourced chief investment officer, or OCIO, is one of the most critical decisions an organization can make. Choosing the right partner can lead to achieving the desired results or unexpected consequences.

Key Takeaways
  1. Institutional investors face an array of challenges in managing their investment programs.
  2. The main reasons why organizations engage an OCIO: governance, complexity and access sophisticated investments and costs.
  3. According to the 2021 Outsourced-Chief Investment Officer Survey conducted by CIO Magazine, interest in OCIO is consistent across client segments.

Institutional investors face an array of challenges in managing their investment programs. Volatile capital markets, evolving investment strategies, growing operational complexities and generally leaner staff than in years past are all hallmarks of today’s environment. Organizations are seeking ways to effectively govern and implement their investment programs in light of these considerations.

For institutional investors, engaging an outsourced chief investment officer, or OCIO, is one of the most critical decisions an organization can make. Choosing the right partner can lead to achieving the desired results or unexpected consequences. What drives an organization to hire an OCIO? What should be considered when selecting a partner? Is there a framework to aid in the decision-making process?

At Aon, we partner with our clients to help them make better decisions with clarity and confidence. We firmly believe that the relationships with investment consultants have driven the growth of the OCIO model and that choosing an OCIO that has grown from investment consulting DNA will help drive the desired results your organization seeks to achieve.

What is an OCIO?

At the most basic level, an OCIO relationship can be described as engaging experts to implement a portfolio strategy. An OCIO is a resource for organizations that take on accountability and fiduciary responsibility for implementing the investment policy of an asset pool by selecting outside managers and ensuring compliance with investment policy parameters, such as asset allocation targets and ranges. Whereas in a traditional investment consulting relationship, the consultant recommends managers, an OCIO selects them and handles other aspects of implementation such as contracting, transition and portfolio rebalancing. An OCIO also manages liquidity and trading costs and shares the appropriate level of fiduciary responsibility with the client’s internal governance committee. Given the increased complexity of institutional investment programs, an OCIO can help investors access the expertise, innovation and scale they need to get the most out of their investment strategy.

Why do Organizations Hire an OCIO?

 

The Substantial and Growing OCIO Market
OCIO AUM, 2007–2022E (Global Data)

Differentiate your portfolio to optimize capital efficiency

Source: Pensions and Investments, Cerulli Associates 

In the world of portfolio management, there has been a significant increase in the level of complexity driven by regulatory changes, increased innovation and sophistication of investment strategies and volatile market activity. This is forcing organizations to outsource more and more day-to-day portfolio management responsibilities to an expert. The data reflects these changes, with OCIO assets growing from $90 billion in 2007 to an estimated $2.7 trillion in 2022.

There are three primary reasons why organizations of all sizes engage an OCIO:

Improve Governance

An organization’s committee, board and investment staff are often under-resourced or stretched to capacity and may not always be able to accomplish stated objectives with existing resources. Good governance – ensuring the parties responsible for decisions have the ability to execute effectively – is the center of an OCIO relationship. OCIOs allow the asset owner to focus on higher-level strategic decisions, and the OCIO executes the strategy, including the real-time monitoring of the portfolio relative to policy. Successful OCIO relationships serve as an extension of client staff and can be customized to fit client needs. An OCIO partner provides asset owners the ability to select the optimal investment strategy and be confident in its implementation and execution.

Manage Complexity and Access Sophisticated Investments

At times, market volatility creates dislocation, which may create opportunities for asset owners of all types and sizes. As investment strategies have become more complex, relative to stocks and bonds, governance committees, boards and investment staff may look to partially outsource the implementation of complex investment strategies. The importance of OCIO flexibility cannot be understated as many asset owners with sophisticated programs may require custom implementation, such as hybrid OCIO, to ensure the proper resources are deployed based on needs. Examples include custom liability-driven investment programs, alternative investments, impact portfolios or niche strategies such as private credit.

Drive Cost Savings

Larger OCIO providers possess the considerable ability to aggregate assets to reduce investment management fees and pass those savings to clients. Many investment managers value the efficiency of a single client, the OCIO and portfolio implementation via a large asset pool and are willing to negotiate meaningful fee discounts with OCIO providers. Some OCIO providers have also been able to negotiate proprietary fee arrangements with other potential service providers, such as custodians, that can be leveraged by their clients.

Increased Demand for OCIO Model

According to the 2021 Outsourced-Chief Investment Officer Survey conducted by CIO Magazine, interest in OCIO is consistent across client segments, though the rationale for selecting OCIO varies by investor type.

Percent That Outsource or Plan to by Organization Type

Corporate Pension   44%
 Public Pension   39%
 Endowment/Foundation   43%
 401(k), 403(b), 457 DC plan   56%
 Other   33%

Source: Chief Investment Officer, Responses are from 85 asset owners from February 8 to March 16, 2021

For corporate pensions, following the Pension Protection Act (which was passed in 2006, effective in 2008), the regulations and legislation impacting ERISA pension plans resulted in a significant increase in oversight requirements given the development and implementation of dynamic investment strategies. As the sophistication of investment models developed beyond the traditional 60/40 portfolio, the existing governance structures at most sponsoring organizations simply were not up to the task of properly monitoring and implementing these types of investment strategies. A system of quarterly monitoring 6-8 weeks in arrears was not sufficient in the new world of dynamic implementation and liability-hedging. More frequent monitoring of key metrics, such as funded status, was a requirement for achieving the overall objectives of the strategy. In addition to more dynamic policy management and complexity in liability-hedging portfolios, plan sponsors have been looking for their return-seeking portfolios to diversify risk and generate alpha. For all these goals, more oversight was needed, which motivated organizations to outsource more and more of the day-to-day management responsibilities to an expert, the OCIO.

Non-profit organizations — including university endowments, foundations, and healthcare systems — have also turned to OCIO solutions. Reasons driving their interests include regulatory for some with the passing of the Uniform Prudent Management of Institutional Funds Act, as well as the lack of size, resources and skills to access and manage complex strategies, such as alternative investments, ESG strategies, impact investing and diverse manager investing. There has been a focus on the cost of having an internal investment team and what it takes to have a fully functioning staff versus hiring an OCIO. There is an understanding that at a certain asset size, an OCIO relationship makes more sense for many institutions.

Public funds vary in reasons for using OCIO solutions. Multi-billion dollar funds often have large staff teams, so they use partial OCIO as extensions of staff for niche areas where they don’t have sufficient expertise in-house. Smaller funds often use OCIOs precisely because they want to implement sophisticated strategies similar to the larger funds but don’t have the staff to do it on their own. Whether full or partial, OCIOs tend to be an extension of staff.

Defined contribution plans tend to use OCIOs more for fiduciary governance, as they less commonly have sophisticated strategies, such as alternative assets. Their needs are more oriented toward monitoring managers, including investment management fees, and making changes as needed. We are most commonly seeing DC plan sponsors choosing to implement OCIO mandates as part of converting to pooled employer plans (PEPs). PEPs are a new type of 401(k) plan first launched in 2021, made possible by the SECURE Act, which relieves employers of many fiduciary duties they have today by bundling services for OCIO, recordkeeping and administrative services with a single PEP provider. For the plan sponsor, this may be an attractive way to deliver 401(k) benefits in a way that is easy to implement and maintain, helps mitigate litigation risk and helps to improve outcomes while controlling costs.

$2.7T

OCIO assets grew from $90 billion in 2007 to an estimated $2.7 trillion in 2022.

Source: Pensions and Investments, Cerulli Associates

The Optimal Outsourced Chief Investment Officer
How Does an OCIO Relationship Work?

There is no singular solution or OCIO model for every client, but there are two main categories of OCIO relationships and one emerging solution:

  • Full implementation is where the OCIO has full discretion over the implementation of the investment policy. They oversee all aspects of investment management as well as back-office operations.
  • There are also hybrid approaches where asset owners outsource the more complex parts of their program, such as alternative asset classes or liability-hedging mandates.
  • Back-office outsourcing is also an area of increased interest for asset owners. Solutions aimed at driving efficiency through outsourcing tasks that include monitoring, trading, rebalancing and managing capital calls for private market investments are growing in demand.

Even with a full OCIO approach, organizations and investment committees still retain a fiduciary responsibility in oversight of the management of the asset pool. They need to focus on addressing the important topics centered around risk tolerance, asset allocation, asset classes and policy. In essence, the OCIO executes the investment policy set by the investment committee or board, with activities such as manager selection, operational due diligence, trading, cash raising, rebalancing, new commitments to private market investments and compliance reporting. The OCIO will deliver standard reporting and inform the organization of its activities. When establishing an OCIO arrangement, it is important to understand what responsibilities are kept and which are outsourced. While OCIO is an investment function, it is first and foremost a governance solution to ensure that desired objectives are achieved.

Why the Traditional Investment Consulting Firm Model Has Evolved into the Ideal OCIO

Across many asset-owner types, investment consultants have a long history and decades of experience in portfolio and investment strategy development via asset liability, asset allocation/spending studies, and investment structure development through manager selection and portfolio optimization.

The investment consulting industry grew several decades ago as institutional investors realized that it was advantageous to individually select asset managers for each strategy rather than having the same investment manager for every asset class and style. Open architecture portfolios like this are now the norm for institutional investors. Investment manager research teams at the largest investment consulting firms possess decades of experience and a global footprint for identifying and implementing portfolios via the best investment firms for each strategy. The asset allocation modeling teams, a core function for consulting firms and distinct from manager research, are structured to give the most appropriate advice for the client and are not incentivized to push a particular asset class, product or strategy.

By design, the consulting model does not manufacture products in the same way as investment management firms. The portfolio management teams at consulting firms select third-party managers identified by experienced research teams, optimize the mix of those managers to provide differentiated sources of alpha, then leverage the scale of the firm to reduce fees. By virtue of using third-party managers, investment consulting firms are not constrained by in-house products and can choose any product for any asset class and from any investment manager – whatever works best for the client. Even when asset managers use open architecture for their OCIO mandates, the outside managers may be reluctant to fully collaborate with OCIOs who are also their competitors. The consulting firm OCIO and the investment management community can more fully collaborate on solutions that benefit the end client without fear that a competitor will benefit from the idea generation in the future.

Further, the largest consulting firm OCIO providers have the scale in their platforms to negotiate fees with asset managers by aggregating assets from all their clients. In many instances, fee negotiations with investment managers can result in lower investment fees than asset owners would be subject to on a stand-alone basis. The size, experience and skill needed to be successful at these objectives represent the DNA of the consulting industry for nearly 50 years.

Examples of How Aon’s OCIO Actions Benefited Clients

While many organizations identify opportunities from market dislocation, consulting firms have the benefit of independence and access to opportunities no matter the source. Non-consulting firm providers, in many cases, are limited to capturing opportunities identified strictly by their internal teams. We’ve seen examples when the speed of decision-making can be a key advantage of OCIOs, whereas many organizations have infrequent meetings and governance processes are built to evaluate and act on a quarterly basis. This is too slow in times of crisis and periods of enhanced volatility, such as the Global Financial Crisis (2007-2009) and during the early days of the COVID-19 pandemic when areas of the market dislocated. Even when a committee can reconvene quickly, coming to a consensus about how to act may be difficult in a condensed timeframe environment. The OCIO helps enable investors to make tactical tilts, capitalize on opportunities presented by market dislocation and ensure the investment policy is implemented according to plan, even when markets are challenging. The following table shows some of the ways Aon was able to use its position as an investment consultant to successfully implement on behalf of OCIO clients.

Improve Governance
Clients focused on strategic issues and delegated Aon authority for manager changes. Aon, unbound by in-house managers, had the authority to remove an equity manager promptly to potentially avoid double-digit losses experienced by late movers.

Implement Opportunistic Positioning
The S&P 500 had the fastest descent in history in the spring of 2020. Aon rotated towards target equities and increased credit spread exposure following the trough.

Enhance Access to Opportunistic Investments
Early in the pandemic, liquidity issues made some securities in niche markets available at attractive prices. Aon implemented an opportunistic credit strategy using specialist managers in the markets affected.

Drive Cost Savings
The average discount is 27% across all managers.1

Source: Aon. There is no guarantee that results or savings will be achieved if you should select AIUSA and/or its affiliated entities to provide services to you. The experience described does not represent all recommendations made to clients,nor does it represent the experience of all clients. The reader should not assume that an investment in any securities identified or a particular recommendation was or will be profitable or favorable.

Evaluating an OCIO Firm 

This series of questions can help assess the competencies of OCIO firms:

  • Does the OCIO have the scale and infrastructure, including back-office technology and people resources, to effectively execute investment strategies ranging from simple to complex?
  • Can the OCIO access all asset classes and allocate assets across a range of risks and markets?
  • Is the OCIO able to access the investment managers it believes are best in each strategy, or is the OCIO bound to proprietary managers run in-house?
  • How transparent are the OCIO’s pricing and fee disclosures across all implementation aspects?
  • Does the OCIO have a financial incentive to include or exclude any particular investment manager or sell its own products?
  • Does the OCIO have a history of meeting and exceeding client expectations?
  • Is the OCIO able to customize its relationship with asset owners to meet specific needs and objectives?
  • Does the OCIO understand the needs and objectives of different asset owner types (such as endowments versus pensions)?
Why Aon?

Aon understands that the OCIO market has grown exponentially over the last decade in terms of adoption by asset owners as well as the number of organizations that provide OCIO solutions. That said, the Aon team believes that the foundation of a large investment consulting firm such as Aon, in many cases, can provide the optimal combination of experience and capabilities to help deliver the most successful outcomes as the OCIO. There are several key drivers of this opinion, as summarized below:

Scale
With $125.9 billion U.S. discretionary assets under management across 204 clients, Aon Investments USA is in a strong position to aggregate assets to negotiate favorable terms with investment managers, build proprietary solutions for OCIO clients, and provide access to strategies across a range of asset classes that may be difficult for smaller investors to implement.2

Experience
Aon Investments and our legacy organizations have provided investment advisory services to institutional investors since 1974. The depth and breadth of experience is critical to the successful development and implementation of multi-asset class portfolios for institutional investors across a wide range of strategies and objectives.

Flexibility
We can work with clients in the capacities of advisory, OCIO and hybrid OCIO mandates.

Alignment of interest
Our OCIO platform is an open architecture using third-party investment managers, allowing us to select what we view as the best options for any mandate, unconstrained by in-house products.

Strategic expertise and collaborative approach
We listen to your needs and goals, then focus our solutions on them based on our broad capabilities across the global investment opportunity set.

Performance
At Aon, 120+ dedicated research professionals covering traditional, emerging, and alternative strategies work with client teams to deliver solutions to our clients.3

Ultimately, clients can benefit from OCIO providers with the structure to implement ideal solutions for their situations – untethered to in-house investment managers – and the scale to be able to execute efficiently and negotiate fees effectively.

 

Endnotes 

1 Based on Aon’s account exposure with investment managers as of 3/31/2022. Discounts represented are calculated as percentage savings from manager-published rack rates sourced from eVestment as reported by Manager. The effective basis point fees are calculated by strategy, applying the Aon account size to the manager’s rack rate fee schedule to determine the effective basis point fee. The information presented reflects estimated fees and potential savings which may or may not be achieved. There is no guarantee that the projected estimated savings will be achieved if you should select AIUSA and/or its affiliated entities to provide services to you. Not all client experiences are the same and may vary significantly from those presented based on a client’s specific circumstances. Active Manager Fee Discount Ranges are as of the date of this publication and are subject to change.
2 As of 6/30/2022 total assets under management represents $125.9 B in U.S. discretionary assets under management advised by Aon Investments USA Inc.
3 Total combined research staff as of 6/30/2022 includes GIC-I Manager Research Staff, and Townsend colleagues from advisory, portfolio management, and strategy teams. Offshore, Innovation and Support staff represent additional colleagues. Some team members have cross-team responsibilities or reporting lines outside the manager research function, including Aon Investments and its global Aon affiliates.

Investment Disclosure

Investment advice and consulting services are provided by Aon Investments USA Inc. (“Aon Investments”). The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. This document is not intended to provide, and shall not be relied upon for, accounting, legal or tax advice or investment recommendations. Any accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute accounting, legal, and tax advice and is based on Aon Investments’ understanding of current laws and interpretation. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The content of this document is made available on an “as is” basis, without warranty of any kind. Aon Investments disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Investments reserves all rights to the content of this document. No part of this document may be reproduced, stored, or transmitted by any means without the express written consent of Aon Investments. Aon Investments USA Inc. is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aon Investments is also registered with the Commodity Futures Trading Commission as a commodity pool operator and a commodity trading advisor and is a member of the National Futures Association. The Aon Investments ADV Form Part 2A disclosure statement is available upon written request to: Aon Investments USA Inc. 200 E. Randolph Street Suite 700 Chicago, IL 60601 ATTN: Aon Investments Compliance Officer

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