The Outsourced Chief Investment Officer (“OCIO”) model became widely adopted about a decade ago and since then the industry has grown rapidly, with well over 100 firms providing some level of these services. Assets under management have reached nearly $2 trillion and are expected to top almost $3 trillion over the next several years (Cerulli Associates). However, how much of that growth has been driven by the firms’ current clients switching from advisory to OCIO services remains to be seen.
Increased competition and consolidation in the marketplace have created a new world where OCIOs are looking to differentiate themselves from their peers. There has also been an emergence of third-party examiners (TPEs) that play the role of gatekeeper between OCIO providers and asset owners. This role is akin to the one played by investment consultants in traditional asset management. TPEs are involved in more than a third of OCIO searches and we have seen opportunity sourcing become increasingly RFP driven over previous years. This has led to OCIOs facing the same market pressure to adhere to industry-recognized standards as asset managers – including even claiming compliance with the Global Investment Performance Standards (GIPS®).
Inherent in the use of third-party advisors are challenges with performance measurement. However, ACA has worked with firms that calculate performance using in-house systems, for both OCIO and advisory clients. As these systems and processes have improved, many OCIOs have determined that a clearer path to creating a performance track record is available by looking to the GIPS standards.
Today, only 17 of the 82 OCIO managers claim compliance with the GIPS standards (as measured by Skorina’s 2019 OCIO report). Of the remaining 65 OCIO firms that are not currently GIPS compliant, 18 of these firms are either currently engaged by or have a proposal out from ACA. This further points to the trend towards GIPS compliance for OCIO managers.
Why GIPS Compliance?
The GIPS standards facilitate the creation of a marketable performance track record for OCIOs. We’ve identified three top reasons for OCIOs to claim compliance with the GIPS standards.
- OCIOs are becoming subject to the same due diligence requirements as other money managers.
- RFPs have started requiring managers to provide composite performance instead of representative account performance.
- RFPs have started asking for, and in some cases requiring, compliance with the GIPS standards.
In a recent article, Cerulli analyst Chris Swansey told Fund Intelligence, “A big source of frustration within the industry as a whole when conducting searches, with or without a consultant, is the lack of uniform performance track records. There’s no one way that all OCIO providers report, whether directly to the client or to search consultants,” He also encouraged OCIO providers to “be prepared to be asked for composite breakouts to ensure there was no cherry picking.” Failing to provide information could lead OCIOs to be screened out during the initial stage of an RFP. “The most difficult thing is assessing OCIOs’ ability to manage money and performance track records,” Alpha Capital principal Brad Alford told Fund Intelligence. “Only a handful are GIPS compliant.”
GIPS Compliance – What Should an OCIO Consider?
The release of the 2020 GIPS standards has forced many firms to assess how the new requirements will impact their business, both from marketing and operational perspectives. The 2010 GIPS standards were designed without OCIOs in mind. However, with the newly released standards, the needs of this sector are being addressed to make the path to GIPS compliance clearer.
There are several basic issues the industry faces when pursuing GIPS compliance. Some will be mitigated by the OCIO’s structure and focus, while others will be exacerbated. Although the following areas are common issues for all firms that claim compliance with the GIPS standards, OCIOs can have additional firm-specific issues.
The Common Issues
1. Firm Definition - Section 1.A. 2 requires that, “firms must be defined as an investment firm, subsidiary, or division held out to clients or prospective clients as a distinct business entity.” For many entities, the OCIO is separated from the advisory business through its own legal entity or regulatory registration. However, for those that are not, the OCIO will need to determine the definition of the firm which can lead to the separation of the portfolios and assets that will be part of the distinct business entity. These decisions will ultimately determine the size of the OCIO, how it is marketed, and composite construction. The firm’s definition is often a main factor in many of the other issues a firm coming into compliance will face.
2. Definition of Discretion - The GIPS standards defines discretion as the ability of the firm to implement an intended strategy. Definition of discretion establishes criteria to judge which portfolios should be in a composite to accurately reflect the application of the investment strategy. Establishing discretion over full multi-asset class accounts is significantly more complex than doing so over single asset class, strategy-level mandates.
For example, an OCIO may only hold discretion over a single asset class and discretion may be limited to asset allocation with the OCIO firm’s authority to hire and fire individual managers being limited in some way. The manager may have “discretion,” but might be subject to informing clients of certain changes, etc.
3. Books and Records – Section 1.A.25 of the 2020 GIPS standards requires, “all data and information necessary to support all items included in GIPS composite reports, GIPS pooled fund reports, and GIPS advertisements must be captured, maintained, and available within a reasonable time frame, for all periods presented in these reports and advertisements.”
This can be a challenge for OCIOs that use third-party managers, especially for real estate and private equity allocations. For an OCIO, the lack of full transparency into underlying portfolios and mismatched reporting frequencies are obstacles that need to be addressed early in the process of claiming GIPS compliance. In addition, OCIOs need to assess the processing of this information in their internal systems so that all information is captured and maintained.
4. Composite Construction – A composite is an aggregation of portfolios managed to a similar investment mandate, objective, or strategy. Under the 2020 GIPS standards, there are three main provisions around composite construction.
- Provision 3.A.1 requires that, “The firm must create composites for the firm’s strategies that are managed for or offered as a segregated account.”
- Provision 3.A.2 requires, “All actual, fee-paying, discretionary segregated accounts must be included in at least one composite. Non-discretionary portfolios must not be included in composites.”
- Provision 3.A.3 requires, “All actual, fee-paying, discretionary pooled funds must be included in at least one composite if they meet a composite definition.”
Firms are not required to create a composite that only includes pooled funds, unless the firm offers that strategy as a segregated account. If a fund is not marketed as a strategy to solicit segregated accounts, and it does not meet any composite definitions, then a composite that contains only the fund as its member is no longer needed. In this situation, a firm will maintain a list of composites and a list of pooled funds and will calculate and present returns at these levels.
In addition, the 2020 GIPS standards allow firms to carve out segments across all portfolios in the firm even if those segments do not maintain their own cash balance. A carve-out must represent a standalone account managed, or intended to be managed, according to that strategy. A carve-out can also be included in a “carve-out” composite and this composite’s returns can be calculated and presented for marketing purposes. Hence, OCIOs can create carve-out composites and showcase their strategies. Additionally, if all the asset classes within an account have been carved out and 100% of the account is captured within various carve-out composites, there is no need to create a composite to house the master portfolio. This is great for OCIOs who normally market their ability to customize asset allocation to their prospects, instead of a defined strategy.
Although some OCIOs have very defined “product-like” solutions, many must address the wide variance of clients’ investment objectives, benchmarks, and asset classes. There are multiple methods, that are best discussed at the outset of the project, that can be utilized to address the “apparent” mismatch between the requirements of the GIPS standards and the business and investment models of the OCIO.
6. Performance Calculations – Provision 2.A.23.C states that, “When calculating time-weighted returns for portfolios that are included in composites, all portfolios except private market investment portfolios (see 2.A.40) must be valued on the date of all large cash flows. The firm must define large cash flow for each composite to determine when portfolios in that composite must be valued.” For OCIOs, this requirement can create issues when there is an intra-month large cash flow between one external manager and another. Reliance on manager-reported data often leads to a lack of transparency into underlying cash flows and therefore intra-month valuations can prove to be significant hurdles when calculating performance at the OCIO. ACA suggests assessing internal systems at the outset of the project to see if the systems can be modified. If not, manual calculations will likely be necessary.
Also, 1.A.35 notes, “The firm must present time-weighted returns unless certain criteria are met, in which case the firm may present money-weighted returns. The firm may present money-weighted returns only if the firm has control over the external cash flows into the portfolios in the composite or pooled fund and the portfolios in the composite have or the pooled fund has at least one of the following characteristics:
- Fixed life
- Fixed commitment
- Illiquid investments as a significant part of the investment strategy.”
This is a huge relief for OCIOs managing portfolios for which the underlying managers have control over subscriptions/redemptions. The OCIO can choose whether a time-weighted return or a money-weighted return, such as an IRR, is more appropriate. Whichever is chosen must be calculated and presented consistently at either a composite or a pooled-fund level.
7. Marketing – OCIOs commonly ask how their past marketing efforts are going to be affected by a claim of compliance with the GIPS standards. In general, marketing is not affected, except for any required information that needs to be delivered to prospective clients and prospective investors. However, the OCIO needs to contemplate how best to address the requirement to create composites that are representative of its strategies, while also maintaining the marketability of the OCIO. The use of supplemental information and additional information can add value to the prospective client and prospective investors while offsetting dispersion dictated by the OCIO’s investment process.
8. Valuation Policies – Every GIPS-compliant firm needs to maintain valuation policies for the determination of fair value. Combined with the need to produce time-weighted returns on a monthly basis, the OCIO needs to create a valuation policy that addresses the mismatch between the reporting frequencies and methodologies of underlying managers. It can be especially challenging to reconcile the nuances around these processes, specifically for real estate and private equity, with the needs of the OCIO.
Watch our complimentary on demand webcast “Performance Challenges and Solutions for OCIOs” discussing the increased demand for a performance standard from OCIOs. This webcast also provides an overview of the benefits, challenges, and solutions that OCIOs might encounter.
ACA Performance Services assists many different OCIOs in their efforts to claim compliance with the GIPS standards and ultimately become verified. If your firm is looking for more information into this effort, please contact Christie Dillard for more information.