Institutional investors – especially foundations, endowments and pension funds – are increasingly deciding to outsource the management of all or parts of their portfolio. A study by consulting firm Casey Quirk predicts that by 2012 the investment outsourcing market will grow to $510 billion, representing 13% of institutional assets and 25% of institutional investors.
One of the forces behind the outsourcing trend is “fiduciary fatigue.” Having successfully managed portfolios through a long period of positive returns, investment committees now face a different set of challenges as they navigate a period of severe stress. For many, maintaining current spending in the face of sharp declines is a huge hurdle. Some investment committees are realizing they just can’t meet often enough to provide sufficient day-to-day oversight to position their portfolios in a high-volatility environment and take advantage of market dislocations. In addition there’s pressure to pare budgets, improve returns and simplify internal operations. Further, the shift into alternative assets on the part of many institutions has added significant asset class, strategy and manager complexity to institutional portfolios.
Committees that find themselves in this challenging position are certainly correct in viewing “CIO outsourcing” – delegation of some or most responsibilities – as a possible option. There’s a continuum of outsourcing approaches and providers: manager-of-manager programs; funds-of-funds; former CIOs offering a diversified model portfolio; investment managers overseeing a broad-based or balanced mandate and investment consultants that are accustomed to providing independent advice and research and evolving to offer outsourcing services on a customized basis. Before proceeding, committees must ask themselves some important questions and work through key issues.
An important subject for investment committees to address is the “some or all” question. They must explore what is the highest and best use of the committee’s time: In other words, what are the critical and necessary areas of focus for the investment committee, and how much do they want to remain involved in making implementation decisions? Many committees choose to focus on asset allocation strategy and high level oversight and delegate the implementation and manager selection to an internal investment office or an outside advisor. There’s no one right answer. It really depends on the makeup of the committee, its resources and the pressures it’s facing.
In addition, committees must consider the true costs of outsourcing. In thinking about whether to outsource, how to outsource and the level of outsourcing, committees must keep an important principle in mind: While there may be additional costs involved in choosing to outsource, it’s really the assessment of the risk-adjusted return net of fees that matters, not the absolute costs involved in implementing a particular model. The cost of oversight varies with the scale and complexity of the portfolio. There are economies of scale in oversight: While 10 or 20 basis points spent on oversight costs for a very large institutional investor might be prudent, that may be woefully inadequate for a smaller entity that is pursuing a high equity and highly diversified strategy. Trends toward increased allocations to alternative assets have created a danger that institutions may actually be spending too little on endowment oversight, rather than too much, since there is a wide dispersion on manager returns, and added resources are required for proper due diligence and oversight of these investments.
Further, investment committees must make sure they understand the advantages and disadvantages of different outsourcing models – for instance, the true all-in costs, varying lock-up provisions and levels of portfolio customization associated with a given approach. Some providers offer a single, one-size-fits-all or model portfolio, while others offer some customization at the asset allocation level, implemented through a series of proprietary funds-of-funds or feeder funds. In some cases, there can be long lock-ups and complex transition issues if the institution decides to terminate the advisor. In addition, it’s important to understand the level of key man risk. Does the firm chosen have sufficient depth of talent to continue to serve the institution well if the CIO overseeing the portfolio departs? Is the track record of a former CIO in their prior role indicative of future success in a new multi-client environment?
And investment committees all recognize that which cannot be delegated. Regardless of the level and scope of outsourcing services a committee selects, fiduciary responsibility cannot be delegated. Trustees and their investment committees are the ultimate bearers of fiduciary responsibility for all investment decisions, and trustees should be mindful about selecting an outsourcing provider that can help them fulfill the fiduciary obligations in the most effective way. Committees should decide the amount of discretion in investment decision-making given to an outsourcing provider only after the committee has been through a comprehensive review of the range of alternatives.
In a challenging environment like the one we are in, this is a discussion – along with a review of whether to outsource, hire additional internal staff or maintain the status quo – of tremendous significance to every investment committee and the institutions they serve.
