Balancing risks and rewards when working with an outsourced CIO

November 18, 2019

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Chris Philips

Chris Philips
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If 91 percent of portfolio movements are determined by asset allocation, then how does an OCIO add alpha? It can be done through behavioral coaching and perspective.

With expectations for capital markets tempered in the near future, nonprofits face the prospect of lower returns in their investment portfolios. How they handle this potential challenge can mean the difference between delivering on their mission or having to curtail operations. An outsourced chief investment officer (OCIO) can help a nonprofit navigate this environment by establishing realistic investment returns and portfolio outcomes.

While that sounds straightforward enough, nonprofits do need to stay vigilant against marketing and sales pitches that overpromise, particularly in times of market turbulence and uncertainty. Sizeable literature exists articulating the challenges consultants face in making recommendations that actually pan out. Talk of outsized returns and minimal-risk strategies are not only unrealistic, but they can also ultimately jeopardize the mission of the nonprofit. For example, a survey earlier this year of institutional asset managers and consultants identified emerging market equities and private equity as the two areas with the greatest return potential. Unfortunately, each of these comes with unique risks that a nonprofit may not be willing or able to accept. A skilled OCIO will help investment committees stay grounded in their expectations, while making sure the risk/reward tradeoff is acceptable.

Capital market forecasts

Capital Market Forecasts

Source: Horizon Actuarial Service, LLC. Survey of Capital Market Assumptions 2019 Edition.

Chris Philips, head of Vanguards Institutional Advisory Services®, says the key to this relationship starts with the basics. First among them: trust. "You want to find an OCIO with whom you are philosophically aligned and whose judgment you trust," he says. "That allows for good conversation so that your organizations investment preferences and risk tolerances are clear. This is the basis for realistic investment return projections."

Secondly, you want an OCIO with a disciplined process, supported by robust technology, and proven client results. Vanguard uses its Portfolio Construction Solutions" tool with nonprofit organizations to perform historical scenario analysis as well as forward-looking risk and return analysis that account for the needs and circumstances of each client.

Still, Philips acknowledges that its tempting for a nonprofit to be swayed by an OCIO forecasting exceptionally high returns—especially when investments account for a big part of their financial picture. His take on dealing with this dilemma? "If it appears too good to be true, it probably is." The irony is that when you compare the investment results of endowments (NACUBO) and foundations (CoF), promises of high returns, diversification, and differentiated performance by their investment managers or offices have been empty, with nearly every peer group underperforming a diversified market benchmark.

Performance of all CoF respondents compared to 60/40 benchmark as of fiscal year ending December 31, 2018

Performance of all CoF respondents

60/40 benchmark is 60% MSCI US Broad Market Index and 40% Bloomberg Barclays US Aggregate Bond Index.

Sources: 2018 Council on Foundations-Commonfund Study of Foundations and Vanguard. Data as of fiscal year ending December 31, 2018.

Performance of all NACUBO respondents compared to 60/40 benchmark as of fiscal year end June 30, 2018

Performance of all NACUBO respondents

60/40 benchmark is 60% MSCI US Broad Market Index and 40% Bloomberg Barclays US Aggregate Bond Index.

Source: Vanguard calculation using data from TIAA-Commonfund Study of Endowments as of fiscal year-end June 30, 2018. All returns are reported net of fees.

With forecasting returns and selecting investment strategies proving to be so challenging, a skilled OCIO will focus their time on conducting a robust analysis of a nonprofits goals, as well as portfolio and capital market forecasts. This will include well-supported assumptions and a range of possible outcomes, not a single figure. "Investing is all about tradeoffs, and those should be accounted for in projections and setting expectations," Philips says. "Any outsized return projections should be accompanied by taking on considerably more risk, or the possibility that a nonprofit is not going to hit its target." In other words, demand candor and ask for both the upside and downside of any investment strategy.

Also, is there consensus among all the parties involved? Committee members of the nonprofit are part of these conversations, and its imperative that there is alignment among the various players in terms of the organizations financial needs, preferences, and tolerances and that they be reflected in any investment strategy. Going for the highest return proposition may sound like a smart decision in the moment, but it likely ignores many important elements, Philips says. An OCIO that takes into consideration the market and economic climate, forecasts, asset class projections, and a nonprofits unique preferences and risk tolerances is the one that you can depend on to devise a sound plan.

A good OCIO can also help a nonprofit—and all investors, for that matter—weather any market storms ahead. Thats because theyve been through countless economic cycles and understand the implications of making changes and, perhaps more importantly, providing the perspective needed to balance the needs of today with the needs of tomorrow. "Its human nature to want to take action," says Philips. "In many cases, however, the best action is sticking with the action already taken, even though thats not always the most popular recommendation among our clients." So while portfolio construction and daily management are two critical elements of an OCIOs financial duties, providing perspective and guidance are equally important. This is what enables a nonprofit to avoid making short-term decisions that can result in long-term pain.

Developed in collaboration with CNBC Brand Studio.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • NACUBO performance information: NACUBO stands for the National Association of College and University Business Officers. The 2018 NACUBO-TIAA Study of Endowments® (NCSE) shows data gathered from 802 U.S. colleges and universities. The NACUBO institutions' portfolios performance was reported to NACUBO voluntarily by NACUBO member institutions and the performance reported may have been affected by changes in conditions, objectives, or investment strategies during the time period of performance displayed. Seventy-nine percent of study participants reported rebalancing at least once in 2018. NACUBO portfolios performance is net of fees. The fees deducted from NACUBO portfolios include: (i) management fees paid to direct asset managers for investment and management services excluding performance fees which can vary widely and may not be indicative of expected rates for a given period; (ii) fund-of-fund fees, which represent aggregate blended management fee rates paid directly to fund-of-fund providers; (iii) advisory fees, which may include consulting fees in addition to fees for investment advisor services; (iv) fund operating expenses; and (v) custody fees. The NACUBO Report notes that individual institutions may pay more or less in fees than is represented by the performance figures provided and that NACUBOs fee deduction method is intended to provide a representation of average fee levels rather than what any individual institution pays.
  • CCSF stands for the Council on Foundations-Commonfund Study of Endowments for Private and Community Foundations® (CCSF). The 2018 Council on Foundations-Commonfund Study of Endowments for Private and Community Foundations® shows data gathered from 143 Private Foundations and 81 Community Foundations.
  • The CCSF institutions' portfolios performance was reported to CCSF voluntarily and the performance reported may have been affected by changes in conditions, objectives, or investment strategies during the time period of performance displayed. Over eighty percent of study participants reported rebalancing at least once in 2017.
  • CCSF portfolios performance is net of fees. The fees deducted from CCSF portfolios may include: (i) management fees paid to direct asset managers for investment and management services excluding performance fees which can vary widely and may not be indicative of expected rates for a given period; (ii) fund-of-fund fees, which represent aggregate blended management fee rates paid directly to fund-of-fund providers; (iii) advisory fees, which may include consulting fees in addition to fees for investment advisor services; (iv) fund operating expenses; and (v) custody fees.
  • Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.