Today's college and university boards find themselves faced with ever-increasing challenges as they attempt to meet the financial needs of their institutions while complying with a myriad of fiduciary responsibilities. The growing complexity of issues facing the investment committees of institutions and their foundations is leading more institutions to shift some of the authority for investment decisions to outside advisors to help cope with “fiduciary fatigue.”
In fact, in the 2012 NACUBO-Commonfund Study of Endowments, 38 percent of the respondents said they had substantially outsourced their investment management function, up significantly from 2010’s report of 34 percent. In an increasingly common outsourcing model—known as OCIO or the outsourced chief investment officer—an institution assigns “responsibility for day-to-day investment management to a qualified and competent external provider that manages a majority or all of an educational institution’s investment funds,” to quote John Griswold, executive director of the Commonfund Institute in Trusteeship (January/February 2013).
Two sets of technical fiduciary standards, known as the Uniform Code of Fiduciary Conduct (UCFC) and the recently developed Uniform Prudent Management of Institutional Funds Act (UPMIFA)—a form of which has now been adopted by 49 states and the District of Columbia—do allow for the “use of prudent experts” to help make investment decisions. However, institutions and their boards still must exercise due diligence and an appropriate standard of care in delegating to an outside provider any responsibility for making investment decisions. They should ask themselves several sets of questions and conduct considerable research. Moreover, the answers must be translated into an effective investment-decision-making process, with carefully defined roles and responsibilities. The board and investment committee must be willing to commit the volunteer and staff resources necessary to fully evaluate the options and, if a new process is adopted, to fully implement it.
As an example of the complexities involved and the care required, we will describe some of the considerations we at the Ball State University Foundation weighed during a year-long study of whether to adopt a new investment process. Our study was conducted by a nine-member task force of six volunteer board members from our investment committee and three foundation staff members—the CEO, chief investment officer, and chief financial officer.
The discussion about outsourcing emerged from our foundation’s asset-allocation study in the spring of 2010. The investment committee had adopted the practice of revisiting this question every three years, but this time the agenda was broadened to include process, governance, and resource issues, particularly in light of the economic difficulties of 2008 and 2009. The investment portfolio ($164 million in June 2011) was being managed by a 20-member investment committee plus the foundation’s chief investment officer with the guidance of one overall investment consultant. The portfolio had a 50 percent allocation to alternative investments (hedge funds, private equity, and real assets) and employed roughly 50 investment managers. The process was very consultant-dependent, as the CIO was the only dedicated internal investment staff.
As a result of the study, the committee decided to explore the outsourcing concept as a way to achieve several specific objectives:
- to provide appropriate resources to conduct the research, analysis, due diligence, and portfolio management needed to effectively meet the investment objectives and manage risk;
- to identify and access the best managers in the hedge fund and private investment arenas—in other words to “punch above our weight”; and
- to introduce a better tactical asset-allocation capability to our investment process, better than what the committee could do on a quarterly basis.
Based on our experience, we advise boards and investment committees considering outsourcing to ask themselves the following:
- What is our investment philosophy? Are all our board members knowledgeable and comfortable with it?
- How effective is our decision-making process for investing?
- Which investment roles or responsibilities does the board want to retain and which ones do we want to delegate or share with an outside provider? Which do we need to add resources for in order to handle internally?
Understanding Your Organization: Mission, Investment Objective, and Access
In considering outsourcing investment decisions, your organization should articulate its investment objective(s). Generally speaking, endowments exist to spend prudently, yet provide the maximum, sustainable support for the institution’s mission. But what do those phrases mean for your organization? Are higher levels of spending per year more or less important than the stability and predictability of spending levels? The spending guidelines in UPMIFA, mentioned above, can be useful in defining and monitoring the level of spending required.
Your board and investment committee should also ask: How does our organization define risk? Investing requires the adoption of a level of risk and the allocation of that risk to various investment opportunities. This risk must be balanced between short-term and long-term risks. In the short term, how much volatility in spending can the institution tolerate in pursuit of its mission? For most endowments, volatility in investment returns translates into volatility in the amounts available to be spent, but the impact may be smoothed out by certain spending-policy calculations (for example, spending 4 percent of the average value of 12 rolling quarters). While short-term risk may be more emotionally stressful, longterm risk is more dangerous to the institutional mission. To feel safe in the short term, you may not take enough risk to achieve the investment returns required to meet the long-term mission of the organization, especially on an inflation-adjusted basis.
A further consideration would be whether your institution has any constraints applicable to its investment process, such as a mandate for socially responsible investing (SRI). How does it calculate whether or not its investment process is adequately supporting its mission? By whether its returns allow support of specific spending levels, meet a targeted percentage return, or meet the average returns of its peers?
What resources—staff with appropriate skill sets and compensation, systems and databases to track and model portfolio performance and manager due diligence, and subscriptions to publications, databases, and external analytical tools—are available to your investment process? The high proportion of alternative investments beyond traditional stocks and bonds that many institutions now more typically use requires the availability of people to perform due diligence, manage risk and liquidity, design the investment portfolio, and report on performance. What time and talent are available from the internal staff or from the members of the board? Does it make more sense to buy or build this talent internally, given the size of your investment portfolio?
Finally, given the size of its assets and existing relationships, can your organization gain access to the managers who can generate the expected investment returns from complex alternative types of investments? Can it gain that access on its own or does it depend on a consultant, a fund-of-funds manager?
While some board members might reject the OCIO model out-of-hand, if one is open to considering the possibility of such a relationship, a survey of the field uncovers a range of investment structures and variations, which the following summarizes:
- Customized portfolio/independent relationships with investment managers. This model looks very much like a consultant relationship and for some might be termed “discretionary consulting.” As in the consultant model, the institution retains the direct relationship with the investment managers and continues to hold title to the assets invested at that level.
- Customized portfolio/commingled pools of investment funds. It can be difficult to invest relatively small amounts of assets, so in this model the institution invests in commingled pools of funds managed by the outsourced chief investment officer to gain economies of scale and access to higher-level managers. The multiple-pool structure allows the outside investment manager to tailor an institution’s investment to its particular asset allocation, using pools of funds in various asset classes.
- Single portfolio. In a structure in which institutions invest in units of a single pool managed by the outside investment manager, that manager has the maximum ability to move nimbly and tactically in volatile markets. Every variation desired in the management of pooled funds, or every phone call that must be made to an internal chief investment officer or the chairman of the investment committee, slows the process and the response time. A comparison of returns over recent history may give evidence of the trade-off between investment returns and client involvement in the investment process.
As part of the process of deciding whether a new investing approach is warranted, institutions might try to develop a “responsibility matrix.” The matrix is a tool that may be helpful in understanding the roles and responsibilities of the participants in the investment process. Try to list all of the investment functions from investment objective and portfolio design down to the processing of cash calls and distributions; then identify the parties currently responsible for each task. As different governance models are considered, the matrix helps illustrate for the investment committee how the roles and responsibilities of the committee and staff would be affected. We found this matrix useful not only during the selection process, but also well into the implementation of the new model as we began to live in the structure that we created.
This process might uncover and help to address an underlying source of resistance to the outsourcing of investment functions. Hiring and firing investment managers may have been a significant portion of the committee’s agenda in the past. Many committee members have enjoyed these discussions and decisions, although an analysis may indicate that managers have been hired and fired at the wrong times and for the wrong reasons. If hiring investment managers is assigned to an outside chief investment officer, members may wonder what is left for the committee to do. Projecting what the items might be on the investment committee’s meeting agendas under the different models may help members understand the changes in their governance role and could lead to more support for those changes.
The Research, Selection, and Implementation Process
Developing a list of potential providers includes considering your current relationships, gathering references from peers, and reviewing relevant publications. At Ball State, we found it useful to request some basic information from our initial list of candidates through a “request for information.” This process helped put our knowledge of providers on more of an apples-to-apples basis and gave us an initial indication of which providers might be interested in a relationship with our university. Reviewing the responses from providers against the characteristics of our institution helped us narrow the pool to a manageable number of semifinalist candidates on whom we then did deeper research. In our semifinalist list, we tried to include our best potential candidates from several models of investment governance.
The initial list of providers and the request for basic information can be accomplished without a significant investment in time and expense. But the next stage requires a serious commitment from both board members and staff: sifting through the information gathered and weighing the possibilities for your institution. We cannot overstate the importance of the education we gained, including an understanding of the issues and factors—many of which were idiosyncratic to Ball State—that served to differentiate among the candidates and indicated how they would relate to our institution.
We found it useful to approach the stage of weeding out the semifinalists in two parts. First we sent them a written request for documentation, including sample contracts and reporting packages. We asked the candidates to submit all their documentation to a secure online site; the candidates had access only to their own materials on that site, but our committee members could review all of the information.
The second request of the candidates was a meeting with our task force at their location so we could meet more of their team and get a better feel for their organizational culture. We submitted a list of questions in advance, which covered four categories:
- The providers’ investment philosophy and process. How do you pursue investment returns? What is your approach to risk management? How do you construct portfolios? How tactical or opportunistic are you in practice?
- The governance process. How will we work together as partners? What will be the role of the investment committee and of its staff? How will we communicate—including how frequently will we meet and what kind of reporting will we receive?
- Business operations. How do you generate revenue, and how much comes from performance fees? How can we properly align our interests and theirs? What is the quality of your “back office”? Will this be a viable business operation in 10 years?
- Costs. What fees do you charge, and what do those fees include and exclude? (The responses can be difficult to compare across providers, because the fees that are explicit or are determined by returns vary by investment structure.)
While our questions provided a framework for our meetings, the discussions were informal and unstructured. That allowed the task force to gain a further understanding of the candidate’s culture and the interaction of its team members.
You will note that investment returns are not part of the criteria we set out, as we identified three problems with ranking candidates by their past returns. First, one cannot invest in the investment returns of the past, but only in the investment process of the future. Second, if the potential provider customizes portfolios client by client, then those portfolios will have had different investment returns. The candidate’s returns as a whole then are not relevant; only the returns of their clients that are most like our institution are relevant. And third, since an institution aims to be a long-term investor, the most relevant returns would be over a long timeframe, possibly up to 10 years. Few candidates had a relevant investing history of that duration as outside managers for institutions like ours.
We conducted these meetings over two weeks. After their conclusion and a review of the due-diligence documentation, we asked the committee members to assign a grade for each of the four evaluation categories and an overall grade to each candidate. Then, using a roundtable discussion, we selected three finalists who were invited to make presentations to the task force in our office. The next day the committee made its selection and forwarded the recommendation to the full board. In the end, the committee selected a provider with excellent resources, a deep understanding of the objectives and culture of a university endowment, a strategic interest in a client of our size, and an interest in integrating with our internal CIO.
Putting the Outsourced Process in Place
Once the decision on a provider is made, the implementation process consists of three major tasks:
Drawing up detailed contracts. Depending on the investment structure of the provider chosen, several documents may need to be negotiated and harmonized, such as an “offering memorandum” (a document defining the terms of a commingled investment fund that applies to all of its investors), a “side letter” (a document modifying the terms of a fund with regard to a specific investor), and a management agreement. You should pay attention to lockups (the length of time from the initial investment to the earliest allowable withdrawal) and liquidity, fiduciary liability and indemnification, and the conditions under which the contract may be terminated, such as a “key man” clause (which deals with situations such as if the CIO leaves the company).
In the consultant model, an institution may have used one consultant who provided services for the entire portfolio but without discretion regarding investments, and money managers who had discretion but only over a limited slice of the assets. In an outsourced chief investment officer model, an institution may now have one provider managing the entire portfolio with discretion over investments, creating a significant concentration of risk. The scope of the relationship needs to be defined, specifying which of the institution’s assets are covered by the outside provider’s services. Of course, the fee also must be determined, and what expenses it covers must be spelled out. If there is a performance-based fee, is it based on relative or absolute performance? Is there a high-water mark? (A high-water mark is the highest prior market value. If a portfolio experiences a negative investment return in one year, then to earn the performance fee the next year the return must meet the annual objective plus the recovery of the prior year’s loss.)
Arranging transition of assets. Each of your existing investments has its own redemption terms, notification periods, holdbacks, and paperwork. It will probably be desirable to stage these redemptions over four quarters and maintain the overall asset allocation and market exposure throughout that process. Financial staff will need transaction reports and statements to track the transition and to continually reconcile portfolio balances. The outsourced provider may need copies of existing fund and management agreements, records of past due diligence, and some history of performance reports and market-value statements. Existing managers may need to be informed of the new reporting relationship, as it may alter reporting contacts and perhaps signature authority.
Changing roles and responsibilities. Staff members will have some new responsibilities while providing continuity for such tasks as financial reporting, capital calls and distribution processing, and liquidity management. Perhaps more important, the investment committee will need to revise its governance role. Time on meeting agendas formerly spent on discussions of hiring or firing the investment manager can now be allocated to discussions of broader investment themes and policies.
For some institutions, entering into a relationship with an outsourced chief investment officer may be the best solution to fulfilling their fiduciary responsibilities. As indicated above, however, a shift to this model is significantly more involved than changing a consultant relationship. The outsourcing field is continuing to evolve with new providers, governance processes, and investment structures—requiring the investment committee to dedicate significant time and effort to the research and selection process. And the subsequent steps required for implementation will impact the structure of the portfolio, the roles and responsibilities of the investment committee and staff, and perhaps even the culture of the institution.
For leaders of endowments and foundations who don’t feel they have the capacity to embark on that extensive a process, there may be an alternative. A business is now developing to perform searches for institutions of possible providers of outsourced investment services. While still young, this field shows signs of rapid growth.
If a board decides to explore this option, several potential criteria should be considered, including information about the searches done for other similar institutions; the company’s knowledge of the basic differences among the various models for delivering outsourced investment services; and, perhaps most important, the company’s independence from any potential conflicts of interest—no selling of services to investment managers or service providers, no financial interests that may interfere directly or indirectly with an impartial search for an outside chief investment officer.
The process we’ve described is, we believe, central to an institution’s performance of its fiduciary responsibilities. It will take extensive time and effort by investment committee members and staff, both before and after a decision to go with an outsourced provider is made. But given the continuing growth in the investment responsibilities of institutions with endowments of all sizes, the kind of process we have engaged in illustrates principles of good practice and can indeed lead to a principled reduction in “fiduciary fatigue.”
Alternative Models of Investment Governance
Over the last several decades, the expansion of investment opportunities, the evolution of the law, and the creativity of both institutions and investment providers have resulted in an increasing number of models for the governance of the investment process. An investment committee should not assume that the way it has always handled the institution’s investments is still the best model. A summary list of evolving models includes:
- Board of directors/bank trust department model. This early form of outsourcing has been around for many years, and many smaller institutions still employ it.
- Investment committee/consultant model. This model became increasingly popular as institutions began to seek outside counsel under the old Uniform Management of Institutional Funds Act (UMIFA) and to venture into new classes of assets as they emerged.
- Investment committee/outsourced chief investment officer (OCIO) model. While outsourcing has gained more prominence lately, it has been around in some form for many years. This model differs from the consultant model in the amount of discretion given to the provider (and taken from the investment committee) and in the way the provider is compensated, often incorporating a performance-based fee.
- Investment committee/outsourced chief investment officer/internal chief investment officer model. This variation of the model above preserves the internal point of contact (for the committee, donors, and development or other institutional staff) and oversight desired by some institutions, while buying the underlying investing infrastructure from an outside provider instead of building the resources internally. Successful integration of the work of the internal and external officers is essential to avoid redundancy and conflict.
- Investment committee/internal staff model. For institutions with an asset base large enough to support the infrastructure and personnel required for their style of investing, this may be the most effective of the models.