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.
Every OCIO should have legitimate concerns about the draft GIPS for OCIOs. And it's not just about gaming the GIPS. They should be concerned how clients and search consultants could misuse the data.
To be fair, it is just a first draft. Even if greatly improved, I believe the GIPS for OCIOs will fall short of its lofty goal due to the nature of OCIOs. They cannot be so neatly categorized like asset managers.
Hopefully this piece brings greater awareness to OCIOs, search consultants and the asset owners currently using or considering "going OCIO."
Ethical OCIOs Lose to Unethical OCIOs
The proposed GIPS draft carries with it the certainty for gaming the system. I am 100% positive this will happen when classifying portfolios in the Required OCIO Composites, and how asset classes are categorized. This article, The CFAI's Proposed GIPS for OCIOs will be Tested by Goodhart's Law, explains how OCIOs, while being technically GIPS compliant, will game the system putting a thumb on the scale.
But hey, "If you ain't cheating, you ain't trying."
Because the ethical OCIOs will initially lose, every OCIO will eventually resort to gaming. GIPS will create the proverbial race to the bottom.
But OCIO GIPS Reporting will be "Verified"
Some OCIO search consultants will be requiring OCIOs to have their GIPS reporting "verified." Verification, as I understand it, simply means did the OCIO follow the GIPS rules as written and not whether there is gaming or if the OCIO is violating the "spirit" of the GIPS rules.
Unless the verifiers push back on the gaming methods described in the article above, verification may be just a hollow imprimatur.
Will verifiers question and push back? But who would know if they did not?
If a verifier sincerely questions and pushes back, OCIOs will just find a "friendlier" verifier. (Think of home appraisers leading up to the GFC.)
"GIPS or Die!"
According to this recent Fund Fire article, search consultants are pressuring OCIOs to become GIPS compliant to be considered in a search. In fact, some search consultants have already announced that they will not consider OCIOs in searches if they are not GIPS compliant.
This "GIPS or die" ultimatum tells me some search consultants plan to greatly rely on the GIPS composite returns to do their job. As noted above and below, this is a problem.
Asset Owners and Search Providers Need to Look Deeper
I do not believe OCIO search consultants, at least the ones I know, will take the easy way out and rely too heavily on GIPS composite returns. They know returns are just "skin deep" and a more wholistic approach is required.
That being said, GIPS returns will no doubt have some relevance. But because of gaming the system and how value-add is not captured (see below,) putting too much faith in GIPS composite returns can lead to wrong conclusions.
Why GIPS Composite Returns ≠ OCIO Performance or Value-add
Imagine an OCIO has 3 pension fund clients that each have a 7% assumed rate of return. So, they are categorically similar, and for purposes of this example, fall into the same Required OCIO Composite. Now consider all the potential different circumstances for these 3 pensions, including:
- Size
- Positive/Negative Cash Flow
- Funding Status
- Mature/Growing/Declining
- Legacy Assets
These unique client factors affect investment policy and strategy, including:
- Risk Tolerance
- Allowable Asset Classes
- Asset Class Ranges
- Cash Overlay / Use of Futures
- Liquidity Needs (Amount of Illiquid Alts)
- Leverage Limits
Now imagine they have different vintages: 5 years, 10 years, 15 years. Investment opportunities can be substantially different depending on the inception dates thus affecting returns between clients in the same Required OCIO Composite.
Within unique client circumstances, an OCIO's performance or value-add is expressed in the following skills:
- Strategic Asset Allocation
- Tactical Asset Allocation
- Rebalancing
- Manager Hiring
- Manager Firing
The plain truth is that comparing composite OCIO returns, GIPS or not, reveals little about an OCIO's performance or value-add.
The Real Possibility of Good OCIOs Ranking Low
The impetus of the original GIPS for asset managers was to avoid "cherry picking" while creating uniformity for asset manager comparisons. For specific asset classes and strategies, GIPS works very well.
Following up on the example above for an OCIO with 3 pensions in the same Required OCIO Composite, they could all be mature plans, with negative cash flow, declining AUM, etc. One is even looking to shutter with a risk transfer to an insurance company and therefore has a 0% allocation to illiquid alts.
This hypothetical OCIO's GIPS returns for that Required OCIO Composite could look terrible even though they perform well with high value-add managing the adverse circumstances of these unhealthy pension funds.
Use with a Grain of Salt
If relying on GIPS returns to make OCIO hiring/firing decisions, asset owners may mistakenly hire the "higher returning" OCIO that delivers lower performance, or value-add. The reverse can also be true when firing an OCIO with positive value-add but with "low returns" compared to other OCIOs' composites.
GIPS composite returns for OCIOs will be less robust and less applicable than the original GIPS for specific asset class managers and strategies. OCIOs are not asset managers so neatly categorized and compared.
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.
About the Author:
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.
