The Optimal Outsourced Chief Investment Officer

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?

 

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)

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:

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.

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.

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.

 

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:

 

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.

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