The key hallmark of successful investing is patience. Knee-jerk and reactive decisions due to short-term market movements or poor rankings are usually the recipe for disaster.
One of the advantages of using an Outsourced Chief Investment Officer (OCIO) is that plan sponsors are no longer faced with the “watch list.” Should we hold on or fire under-performing money managers?
But how do plan sponsors know when to put their OCIO on the watch list? After all, the only performance reports and attribution analysis they review are provided by their OCIO.
Here are some guidelines and contextual musings plan sponsors should consider when evaluating their OCIO’s performance; and whether to put them on watch.
Short-term Performance
When I was an investment manager, it seemed almost like clockwork that if our strategy’s 3-year performance fell below median in its universe, we were put on the watch list. And if we were below median, or below the benchmark for the 5-year period, we were terminated. Some investment consultants (and trustees) followed these rules as if a commandment from on high: “Thou shalt fire if…”
That was in the early 2000’s. Today, plan sponsors are more cautious of robotically firing as they have begun tracking the post-termination performance and have learned such behavior has come to mean “firing low” when they should be riding out the cycle. Academic studies show that plan sponsors are usually better served by staying put.
These lessons should be applied to the performance of your OCIO. Short-to-intermediate under-performance may be the precursor for future out-performance. Too often plan sponsors change managers and investment consultants precisely at inflection points. They fire their “cold” OCIO and replace with a “hot hand” only to be whipsawed. I have seen this too many times to count with the markets punishing their impatience.
If you choose to rely on universe rankings to put on watch, raise the duration. There is no objectively optimal length, so perhaps 5 years to be put on watch. And for termination, increase to 7 years and 60th percentile, as opposed to just 5 years of below median. These simple changes will allow longer-term strategies to come to fruition and reduce the work, headache and cost of OCIO turnover. “Money flows to the patient investor.” ~Warren Buffett
At your next meeting ask your OCIO, “If our plan’s universe ranking was below the 60th percentile over the last 7 years, would it be reasonable to replace you?”
Continual Course Correction
Although your OCIO may never cross the Rubicon to be put on watch, plan sponsors still need to continually monitor. Also, the OCIO should always be looking to improve their process and results. There are 5 functions every OCIO performs that determines investment success:
· Strategic Asset Allocation
· Tactical Asset Allocation
· Active Manager Hiring
· Active Manager Firing
· Rebalancing
It is entirely possible that your OCIO may not be “firing on all cylinders.” This can only be known if analysis and measurement is taken for each of these 5 functions. Certain functions can be put on “micro watch” to heighten the knowledge that one or more of these need attention.
By determining the OCIO’s ability in each of these functions, plan sponsors and the OCIO can discover fixes and countermeasures to improve future outcomes. So, it may not be that the OCIO is on watch overall, but it will be known how to do better.
Ask your OCIO to document their value-add in each of these functions. Or, hire an independent OCIO monitor to gain this powerful benefit.
Are Plan Sponsor Restraints a Factor?
Rare is the OCIO mandate that gives the OCIO carte blanche to do anything under the Sun. There will still be an Investment Policy Statement (IPS) that the OCIO follows that was constructed under the guidance of the plan sponsor. It may be that the IPS is too limiting with regards to a certain asset class, credit rating, foreign investments, illiquidity, leverage, etc.
When considering OCIO performance, plan sponsors need to be aware of this possibility. They also need to be aware that easing such constraints in response after the fact, may be akin to chasing performance and thus should be wary of making a reactive change.
Non-Performance Concerns
There are many non-performance factors that plan sponsors should consider when monitoring their OCIO’s services. These include personnel changes, drastic strategy changes, ownership changes, fee increase, ESG philosophy, proxy voting, etc. I am not sure if this is an urban legend, but I have even heard of an investment consultant fired for cheating at golf!
Plan sponsors need to vet such issues when they arise to ensure that interests continue to align and small matters do not metastasize into larger ones. If the OCIO does not satisfactorily correct the matter, the plan sponsor may demonstrate their seriousness and put them on watch.
Is Poor Past Performance a Precursor or Trend?
When longer-term performance is in the top or bottom quartile, it’s easy to judge an OCIO’s performance. The problem comes when they are in the middle over longer periods or near the bottom over shorter periods. These “grey zones” are where plan sponsors need to take a deep breath and ask if this performance is a precursor for a rebound or a longer performance trend.
If the analysis of the 5 functions shows constant change and performance has been poor, this indicates that the OCIO’s constant tinkering is not adding value nor is there a demonstrated long-term strategy. On the other hand, if change has been muted and the strategy maintained with poor results, the strategy may be poised for gains once the market winds shift. This is the ultimate conundrum faced by plan sponsors- be patient or do something.
I hope this short essay helps plan sponsors make prudent and profitable decisions when it comes to managing and monitoring their OCIO.
Questions or Comments?
I would love your feedback. Please either comment on the thread or email me at admin@OCIOmonitor.com.
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