INTRODUCTION BEST PRACTICES

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1 INTRODUCTION The importance of selecting the proper Outsourced CIO (OCIO) cannot be overstated. As fiduciaries, trustees are expected to act in the best interest of plan participants and their beneficiaries. To fulfill this role, trustees must identify the most qualified investment professionals to manage funds where millions (or billions) of dollars are at stake. In many ways, outsourcing the management of a plan only heightens the importance of making the right decision when compared to a traditional consulting mandate. An OCIO will advise on or directly implement critical issues such as investment policy design, asset allocation, and manager selection, which lay the foundation for a fund s future success. Given that the trajectory of a fund may well hinge upon selecting the right OCIO, this decision should be made with thoughtful consideration and rigorous due diligence. Further complicating this decision is the growing complexity of the OCIO provider landscape. Firms from every corner of the financial services industry are now offering some type of outsourced investment management, with very disparate business models and fee structures. To assist trustees in making informed decisions, we present a list of best practices for selecting an OCIO and vital questions to ask in the process. BEST PRACTICES There are many ways to search for and compare OCIOs, and it is easy to get lost in the minutia. With over three decades of experience providing these services and adapting to an evolving industry, Meketa Investment Group has identified best practices to streamline the process of selecting a skilled OCIO. To simplify and organize the search, consider the following best practices: 1) allocate sufficient time, 2) evaluate the organization, 3) analyze the services, 4) assess the breadth of resources, 5) evaluate the track record, 6) assess transparency, and 7) evaluate the fee structure. Allocate Sufficient Time Given the magnitude of this decision, adequate time should be allocated for planning, research, analysis, interviews, and onsite/finals meetings. Begin with a clear understanding of the most pressing issues concerning your fund. Then objectively assess the fund s ability to address those issues with existing/internal resources. The disparity between the two will help ascertain the best use of an OCIO. This will require assessing the Board s investment acumen, limitations, requirements, and time constraints. This assessment will help determine the required scope of services (i.e., the amount of influence an OCIO should exhibit on the overall fund.) For example, does the Board wish to fully outsource management of the fund, or are there some aspects of the investment process (e.g., asset allocation) where they prefer to retain some degree of control? To gain a thorough understanding of several firms capabilities, issue a detailed RFP based on this required scope of services. Be sure to include minimum qualifications and questions relating specifically to your fund. Oftentimes, funds borrow RFPs from peers that include general, common questions. We believe that the RFP process is much more insightful and efficient, however, if the document is customized in some way. Customizing the RFP will M E K E T A I N V E S T M E N T G R O U P 100 LOWDER BROOK DRIVE SUITE 1100 WESTWOOD MA fax

2 provide insight into topics that matter most to the Board and will help differentiate the various respondents. While this is initially more time consuming than issuing a standard RFP, it will end up saving even more time later in the process. All RFP responses should be thoroughly reviewed. Pay particular attention to whether a candidate is using canned answers that may not directly answer the question, or if they took the time to thoughtfully address each point. This will be your first indication of the quality and customization of a candidate firm s work. If necessary, follow-up directly with candidate firms to clarify responses or request additional information. Once RFP responses have been sufficiently reviewed and analyzed, schedule a finals presentation at your location or onsite visits with each finalist candidate. We believe that onsite visits, if possible, are the best way to truly assess the quality and compatibility of an OCIO firm. They allow you to meet a much broader set of employees than the two or three people that typically attend finals presentations, and provide the time to discuss a wider range of topics in a greater amount of depth. Onsite inspections can provide important information related to organizational depth, employee morale, organizational efficiency, and quality of resources. The Board should gain a sense of the team s investment expertise, communication style, rapport, and compatibility. These intangibles cannot be assessed otherwise and are vital to finding the right fit. Many Boards simply do not have the time to conduct multiple onsite visits, however, and choose to hold finals presentations at their own offices instead. The limited time given to each presenter means maximizing efficiency is critical. The Board can accomplish this by providing some direction in advance. Are there specific aspects of the firm or investment process that you want candidates to emphasize? Is there something unique to your fund on which you would like each candidate to opine? If you are comfortable, providing candidates with information about the fund s current investments can help focus the presentation and provide an initial sense of how each finalist would manage your fund. Finally, be prepared with a list of questions to ask each finalist. Asking each finalist the same question can provide an easy apples-to-apples comparison of the answers, while asking more specific questions can provide valuable insight that was not included in the initial presentation. Evaluate the Organization The more information that can be obtained about an OCIO, the greater the chance of selecting a qualified strategic partner and avoiding an expensive mistake. Seek to gain an in-depth understanding of candidate firms, beginning with: History Potential Conflicts of Interest Ownership Management Structure Organizational Structure/Affiliates Investment Committees Assets Under Advisement Compliance/Code of Ethics Number/Type of Clients Operations/Internal Controls Clients Gained and Lost Technology Resources Size of Research Staff Menu of Services Team Stability/Succession Planning References 2

3 All OCIO firms will be able to provide some level of detail on these topics. Make reasonable comparisons, placing a high value on objectivity, stability, investment expertise, OCIO experience, and ability to customize a solution to fit your needs. The best partnerships are those with aligned goals and a common mission. A firm s ownership structure can be a key tool to promote alignment of interests and long-term stability. Is the firm independently owned? Are key personnel (including non-investment professionals) owners of the firm? What compensation structure does the firm have in place to ensure they can continue to attract and retain top investment talent? In addition, inquire about each firm s mission and core values. Request a copy of their code of ethics manual. Is the firm independent? What are their sources of revenue? Do they provide full transparency into their various lines of business? Also vital to the alignment of interests is a firm s position on fiduciary responsibility. The Board should expect any OCIO to act as a fiduciary and be willing to put this in writing. In addition, pay close attention to reputation. Is this an organization that has a long history as a trustworthy and valued partner in the industry? Potential conflicts of interest are particularly important in the OCIO space where Boards are outsourcing a large degree of investment control. As such, the Board will often not have the opportunity to assess each individual investment decision for potential conflicts until after the fact, or perhaps not at all. Does the firm have any direct or indirect relationships that could compromise their objectivity? Does the firm manage any of their own funds/products in which they invest OCIO assets and potentially get paid twice? While potential conflicts do not necessarily lead to realized conflicts, the safest approach is to avoid them altogether. Analyze the Services A critical step in selecting the right OCIO is to understand their full range of services and the degree of customization that they allow. What are the firm s core competencies? Do they have in-house expertise in each aspect of the investment process? What is their competitive advantage and how do they differentiate themselves? Do they offer services that other firms do not? Identify candidates whose competencies match your fund s scope of services, at a minimum. Consider not only the fund s current requirements, but also anticipated changes. For example, if the fund has no alternative investments today but may potentially allocate there at some point in the future, seek an OCIO who is experienced in both traditional and alternative investments. Ask for examples of work and copies of any reports or research that could be expected from the firm on an ongoing basis. Evaluate the firm s internal investment process. A well-defined, repeatable process for identifying and implementing investment ideas provides comfort that firm s past performance can be repeated in the future. How does the firm source new investment ideas? Do they conduct their own proprietary research or solely rely on third parties? How do investment ideas flow from identification to implementation? Who is ultimately responsible for making these decisions? While the investment process of an OCIO can be extremely complex and include an overwhelming number of steps, it is important to analyze as many as possible to get a true sense of how the firm adds value. For example, how do they approach asset allocation? Do 3

4 they rely purely on quantitative models, or is there room for qualitative input? Do they advocate sticking with long-term asset class targets, or do they seek to add additional value through shorter-term tactical shifts? If the latter, what is their demonstrated expertise in this area? What risk management systems are utilized? What is the screening and due diligence process for manager selection? How do they go about manager monitoring, watch status, and termination procedures? How do they determine appropriate benchmarks? How do they ensure that all clients are treated equally and fairly? How do they ensure that all client accounts remain within their stated investment guidelines? Below is a list of important topics that should be discussed with each finalist candidate: Transitioning New Clients Public/Private Markets Expertise Asset Allocation Process Manager Meetings/Monitoring Asset Allocation Models/Theory Performance Measurement Tools Investment Policy/Objectives Compliance Views on Active/Passive Investing Performance Attribution Research Teams/Asset Class Coverage Risk Management Original Research/Publications Systems/Software Manager Selection Criteria Cost Savings/Fee Negotiations Due Diligence Process Client Service Asset/Liability Analysis Portfolio Transparency One differentiating factor to consider is the customization of services. This is a key aspect to finding a successful partner in managing the fund. Will the Board be satisfied with a one-size-fits-all approach? Is the Board able to choose the degree of outsourcing? Can this balance be modified over time? Many OCIO firms do not have the resources or desire to provide customized services, and thus anything less than a fully outsourced mandate is not possible. Are there any unique aspects of the fund s current situation or long-term goals that may not be shared by the rest of the OCIO provider s clients? Is the OCIO firm willing and able to think creatively to accommodate this? Assess the Breadth of Resources A qualified OCIO firm should have broad resources reflecting a significant investment in personnel, research, and technology. Seek to identify a firm with qualified personnel who have relevant education and experience. Research and client service professionals whose experience is specific to this industry and who have earned designations such as the CFA or CAIA typically provide a high degree of expertise for institutional funds. Assess the quality of the people making key investment decisions. Is there a sole Chief Investment Officer with full autonomy, or does the firm utilize a team-based approach? Does the Board have a strong preference for one model over the other? Do the key decision-makers have sufficient experience directly managing money as opposed to solely providing investment advice? Do they have a track record of success? Are they a good personality fit with the Board? While the investment staff is critical, other areas of the organization are important as well. The investment effort should be fully supported by other departments including operations, 4

5 administrative services, and technology. One cannot overemphasize the importance of having adequate non-investment staffing and support, which directly translates into superior client service. Finally, the OCIO firm should be utilizing industry-standard software, performance and risk measurement tools, manager databases, etc., to ensure comprehensive services. Firm-wide technology should include the latest network and data collection/analysis techniques available. The firm should have a disaster recovery policy in place, as well as procedures ensuring privacy. Reporting capabilities are important and should be customizable to an extent. A quality firm will invest in technology and maintain the highest industry standards to safeguard your fund s proprietary information. Evaluate the Track Record Evaluating an OCIO firm s track record may seem like a straightforward exercise, but it often proves to be far more complicated. Unfortunately, some OCIO firms do not provide a track record on the grounds that the uniqueness of each client mandate makes an overall track record meaningless, but most are able to provide some record of historical performance. The first step in analyzing an OCIO track record is to clearly understand what it is that you are analyzing. Is this a composite of all of the firm s OCIO accounts? Are they equally-weighted or asset-weighted? Does the record of each individual client begin when the current OCIO took full control of the assets? Does the composite include terminated accounts? If it is a single representative account, what are the variables that make that account the most relevant? Is it really the most relevant, or is it the account with the best performance? Is the performance shown gross or net of fees? What is an appropriate benchmark? How does the track record look on a risk-adjusted basis? What were the main drivers of outperformance/underperformance? While a firm s track record is an important piece of the puzzle, one must be careful to avoid placing too much emphasis here. All track records are inherently backward-looking, and choosing an OCIO provider is a forward-looking decision. Furthermore, as described above, making true apples-to-apples comparisons among various OCIO track records can be extremely difficult. Thus, while a historical track record can serve as a proof statement that an OCIO has added value for their clients, it should be kept in the proper perspective. Assess Transparency Transparency is a critical issue, particularly for funds transitioning from a traditional consulting relationship to OCIO. Through an OCIO relationship, trustees are able to outsource some or all of the investment process, but they are unable to outsource fiduciary responsibility for oversight of the fund. Retaining the same degree of fiduciary responsibility but now with less day-to-day control can be a difficult balance. As a result, the degree of ongoing transparency provided by an OCIO is an extremely important consideration. Transparency varies significantly among OCIO firms. Some provide only very high level information on a quarterly basis, while others can provide more regular and detailed reports. Some providers only directly engage clients at formal review meetings, while some are more open to ad hoc communication. As a result, the Board s preferences in terms of transparency 5

6 and communication should be assessed and clearly communicated to candidate firms ahead of time. Along with the detail and frequency of communication, it is important to understand with whom you will be communicating. Who will be primarily responsible for servicing your account? What is their experience in dealing with similar clients? Are they a good personality fit with the Board? Will you have regular access to the key investment decisionmakers? How often is the OCIO willing to travel to present to you in person, and who will they commit to these meetings? Different Boards will require different levels of transparency from their OCIO, and finding the right fit is a critical piece of a successful long-term relationship. Evaluate the Fee Structure While the fees charged by OCIO providers can vary significantly, so can the fee structure itself. The three main categories are cost-plus fees, all-in fees, and performance fees. All three structures have potential advantages and disadvantages. In a cost-plus structure, the OCIO quotes only their fee (typically in basis points). It is important to understand what exactly is included in that number (e.g., legal expenses), and what is not included (e.g., third-party manager expenses). In other words, the client will pay the OCIO provider s fee plus the fees of any money managers that they engage. The advantage of this structure is that the incentives of both parties are fully aligned. The OCIO has no incentive to hire active managers with high fees or passive managers with low fees; the only consideration is to generate the best net-of-fee performance possible. The downside to the cost-plus structure is that the total fee paid by the client (i.e., including all manager fees) will fluctuate over time. While most OCIOs should be able to provide a reasonable estimate of this total fee, it will ultimately change with the underlying investments. With an all-in fee structure, the OCIO provider quotes a total fee including all underlying manager expenses. In other words, the client pays the OCIO, who then pays the underlying managers out of their own pocket. The advantage of this structure is cost certainty. The fee paid by the fund will always be the same, regardless of the underlying manager roster, asset allocation, etc. The disadvantage lies in a potential misalignment of incentives. Under an all-in fee structure, the OCIO provider s fee is essentially the spread between the quoted fee (i.e., what the client pays) and fees paid to the underlying managers. Thus, minimizing the manager fees is the equivalent of maximizing the OCIO provider s fee. This could create an incentive to choose the cheapest managers rather than those of the highest quality. A performance fee structure certainly has the potential to create the best alignment of interests, but is also the most difficult to implement. Most performance fee structures are a combination of a fixed fee and an incentive fee, but what is the right mix? What is the appropriate benchmark to measure relative performance? What is the appropriate time frame? How will investments with lagged performance reporting (e.g., private equity) be handled? Performance fees often sound like the best alternative in theory, but can be very difficult to implement in practice. 6

7 SUMMARY The search for an Outsourced CIO can be a time consuming and laborious process; however, it is arguably one of the most important investment decisions the trustees will make on behalf of their fund. It is imperative that the Board devotes adequate time to perform rigorous due diligence to identify an OCIO that is able to provide the highest level of investment performance, client service, and transparency to suit the fund s needs. A thorough search process will allow the Board to gain an understanding of the OCIO s organization, services, resources, and cost structure, likely producing a strong partnership that will benefit the fund for the long term. 7