By Brian A. Schroeder, the founder of OCIO Monitor, a specialty consulting firm that provides due diligence of investment consultants and outsourced chief investment officers.
It is easy to know if an asset manager is adding value- compare to the correct benchmark. But for an OCIO it is a different story. First and foremost, what is the correct benchmark? (I will answer that later.)
Further complicating the matter is an OCIO's many duties, including:
- Strategic Asset Allocation
- Tactical Asset Allocation
- Rebalancing
- Cash Flow Management
- Active Manager Hiring
- Active Manager Firing
- Compliance
- Performance Reporting
There is virtually an infinite number of permutations to potential portfolios. In addition, the OCIO usually does not have free reign. They must work within constraints imposed by not only the client's guidelines, but also the unique financial circumstances of the client, some of which could be dictated by regulations like ERISA or by the IRS.
The Two Reasons Clients Don't Know if their OCIO Outperforms
The first reason preventing asset owners from knowing if their OCIO is outperforming is that the OCIO provides the only performance reports normally reviewed. They control the narrative as well as the design of the total plan benchmark. In other words, the OCIO puts "their best foot forward." Some even dress-up their performance with creative benchmark manipulation summoning the specter of phantom alpha.
I have even seen OCIOs report client returns that are "above benchmark" and simultaneously bottom quartile of a representative peer universe. It's true!
The second reason is there is no objective and unbiased benchmark. Let's go back to the S&P 500 example. Evaluating a domestic, large cap equity manager is easy because a comparison is made to an agreed-to and objectively defined benchmark. There are no grey areas nor unique client circumstances muddying the water- it is a binary conclusion.
But What About Peer Universes?
Peer universes are indeed helpful and provide useful information for determining how well an OCIO is performing. But these are limited for two reasons. The first, as described above, is that financial circumstances and constraints are unique for every client. So, comparing to a universe is muddied by client circumstances.
Only if performance falls into either the left or right tail can an asset owner confidently say whether or not their OCIO is doing a good job. More likely, assuming a normal distribution, performance will fall near the middle. It very well could be that an OCIO with a 70th percentile ranking could actually be adding more value than an OCIO with a 30th percentile ranking.
But the CFA Institute will soon have GIPS reporting standards for OCIOs that will make comparing performance more transparent and helpful to asset owners. Well, maybe. The same problems apply as using a broad, peer universe. HOWEVER, there is another problem that will arise. Following Goodhart' Law, OCIOs will adapt and manipulate their "GIPS compliant" reporting.
There is no OCIO Benchmark. So, What Should Clients do?
Unique client circumstances make no two OCIO clients alike. For example, an OCIO may have 3 pension fund clients that have the same ROA assumption and subject to ERISA. But consider the following circumstances that prevent a true "apples-to-apples" comparison:
- Total Plan Size
- Positive/Negative Cash Flows
- Growing, Mature (and Shrinking), or Frozen
- Current/Projected Funding Status
- Vintage with OCIO (affects selection of managers and illiquid investments)
- Client Guideline Constraints
Clients should use both a peer universe and a passive and unchanging plan benchmark to judge their OCIO's or investment consultant's performance. And if their ranking in a universe is not top quartile over 5 or more years, they should seek an independent and objective review to discover if and where value is being added or lost.
All posts are the opinion of the contributing author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the author’s employer.
Brian A. Schroeder is the founder of OCIO Monitor, a specialty consulting firm that provides due diligence of investment consultants and outsourced chief investment officers. He has over 30 years of investment experience, as both an institutional manager and consultant.
He is the leading objective and unbiased due diligence provider on behalf of institutional plan sponsors. He has worked for pensions, foundations and endowments with assets up to $15 billion. Besides quantitatively determining their value-add and discovering behavioral finance heuristics, he is likely the leading expert in benchmarking and performance reporting transparency. He has been consulted by academics and recently presented to the Securities Exchange Commission’s Division of Exams’ investigators on how to spot performance reporting fraud when conducting routine firm inspections.
Schroeder has spoken at the International Foundation’s Trustee Master's Program, the Investments Institute, and the ISCEBS Symposium. In July 2014, Benefits Magazine published his article “Multi-balanced Model: The Missing Link in Investment Approaches?” and, in May 2019, “3 Simple Strategies for Adopting a Passive Investment Consulting Approach” and, in July 2020, “Investing in Response to the Covid-19 Response.”
His analysis is novel by quantitatively scoring the value-add of investment consultants and OCIOs in their five main duties- strategic asset allocation, tactical asset allocation, rebalancing, active manager hiring, and active manager firing.
Schroeder has a Bachelor of Arts degree in economics and a Master of Science degree in financial analysis. He served for 3 years on the Riverton, Utah Committee for Economic Development and is a volunteer at the Salt Lake City YWCA.