aiCIO’s Year in Review: The Intricate Economics of (Outsourced) Investment Labor

The anecdote might have ended there, if not for one twist: The $825 million in capital wasn’t the only university asset that would trace Interstate 70 southeastward. Christopher Bittman—until this point, the endowment’s chief investment officer (CIO)—would be accompanying the funds as the newly hired CIO at Agility.

A plethora of issues exist regarding such a move; some are spoken of openly, others only mentioned in hushed tones. The latter, frankly, is the potential conflict-of-interest that arises out of a board outsourcing its endowment management to a firm that has or will hire its CIO. The former are the commonly perceived outsourcing pitfalls (lack of control and transparency, fiduciary responsibility, cost), and while they might seem like the quotidian litany of investor concerns, none are trivial, and none can be ignored. Add to this list the issue highlighted by Bittman’s move —that this furious race by asset managers to consume both talent and capital suggests that outsourcing is a profitable business, and that investors should be wary of any investment craze—and you would not be out of line in wondering why anyone outsources at all.

So, why is there almost universal agreement that such a solution is a positive one for many of the world’s asset owners?

Outsourcing, as a word, does not hold altogether positive connotations in American society. For a particular segment of the country—those (unlike both the ditch digger and the entrepreneur) whose often union-based livelihood is at the mercy of the harsh calculus of cost of labor—the word creates images both of poverty there (dirt floors and sandals, $0.30 an hour) and poverty here (food stamps, shame). It is particularly ironic, then, that this group’s pension investment management increasingly is being outsourced.

“In the corporate defined benefit world, there is an increasing trend toward outsourcing,” says Rick Campbell of Northern Trust, stating the simple but commonly held belief among both asset owners and asset managers. “In the past decade, many corporate plans have seen an overfunded plan turn into an underfunded one—twice. They now say, ‘It’s not fun anymore; the gravy train is over.’ For them, it’s all pain and no gain around pensions. As a result, many have shut their plans to new entrants and sometimes new accruals, and they often are looking for outsourced solutions such as liability-driven investment (LDI).”

Add to this impetus ideas of core competency (for most companies, not investment management) and further thoughts of risk reduction, and a common rationale emerges. The structure of the solution, however, varies wildly.

Once the initial Rubicon of whether to outsource has been crossed, end users will find it best to think in terms of degree. The first degree: the vertical silo approach, where a certain percent of total assets is outsourced to a third party. The second degree: the “sleeve” approach, where a portion—often, alternatives—is outsourced to a vendor who will direct the portfolio. The third degree: the robust outsource, where a fund’s board works with a vendor or consultant to implement a full externalization of their portfolio management. Offering either a range of proprietary products (usually chosen with the help of a dedicated adviser) or acting more as a manager of various external products, such vendors are certain that the outsourcing trend is only growing. Third-party projections support such claims, too: A recent Casey Quirk study predicts that the current $195 billion outsourced to third parties will grow to upward of $500 billion come 2012.

Yet, clearly—for corporate headquarters from Boston to San Diego still have office space set aside for pension investment teams—not all potential clients have been convinced. One issue (the perennial one, of course) is cost. “God, I get asked about insourcing versus outsourcing every day, and cost is always at the center of it,” says Charles Skorina, a San Francisco-based executive search consultant focused on chief investment officers. The cold mathematics of the situation are this, Skorina says: “You figure it costs about $1.5 to $2.5 million to run a shop in-house, depending on what you pay the CIO. You add in two full-time professionals, a researcher, and an administrative assistant; then, you add in rent, overhead, databases subscriptions, and travel. You really can’t expect to do it for less than $1.5 million.” When compared to a major outsourcing firm’s 50 basis points, this equation starts to make sense at a relatively low asset level but, as many point out, such basic math misses the premium, both positive and negative, of outsourcing’s other externalities.

“Most clients, when they come to us, are not only relieving themselves of an internal investment team,” says Mary Choksi, founding partner at Arlington, Virginia-based outsourcing firm Strategic Investment Group, “but also are relieving themselves of risk management fees, consulting fees, and the eventual increase in staff.” Yet what of the positive externalities a sponsor gives up in return for such cost savings? While such savings are mentioned regularly as the major benefit of any form of outsourcing, the equally cited drawbacks are a loss of both transparency and control.

It need not be. “Concerns over transparency can be pretty much erased,” Choksi says, implying that the issue is more tilting at windmills than serious concern. “Ideally, we try to tell them that we are an extension of their staff, and we live that way. We provide a complete reporting package: clear info on every manager used, a whole range of risk reports showing where absolute and active risk is in a portfolio. Also, we invite clients to a quarterly investment committee meeting.” Additionally, she points out, clients have a direct relationship with their custodian, if they so choose.

The control issue is equally a false enemy, Choksi believes. “I think, in many cases, they feel they gain control,” she says. “If you are understaffed, you are acting actively all the time—just not intentionally. If we communicate this correctly, they can come to the conclusion that delegation is meant to bring resources to a portfolio—thus enabling fiduciary control, not taking away from it.” The key, Choksi says, is customization: “Clients might say that they want to meet managers before we employ them. Some might want to meet them eventually, given that they have seen the details beforehand. Other clients, high-net-worth individuals mostly, might want to hear from a manager a maximum of once a year— but that’s not seen with institutions.”

The American Dream of retiring at age 55 with full benefits is as dead as the furnaces of Bethlehem Steel. In turn, the capital pools that supported such benefits will disappear one day. The same cannot be said, of course, for America’s endowments and foundations: With their eternal investment horizon and unique liquidity constraints, there is no limit to how large they can get—and this means that the business of securing control of and managing their money is a serious and competitive one.

Colorado’s Bittman is but one example of the fierce competition among asset managers looking to lure nonprofit capital; in recent months, Rice University’s Scott Wise left to work at TIAA-CREF, and Goldman Sachs quietly has been looking to attract a similarly credentialed investor into its fold. The thought, clearly, is that former endowment managers will know what endowments are looking for—and, more cynically, will use their connections as a catalyst for securing outsourcing business. The overarching theme, however, is not that it’s a sales job; unlike pension plans, which usually outsource in hopes of reducing balance-sheet risk and focusing attention on their core business, endowments (and, to a lesser degree, foundations) are doing so in hopes of mirroring the best-in-class behemoths that populate this prominent silo of institutional investing.

While they would be the first to admit that they failed to comprehend the importance of liquidity during the 2008 crisis, endowments such as Harvard’s and Yale’s have outperformed any reasonable benchmark since they began to implement the “endowment model” nearly two decades ago. Example: 10-year annualized returns for the Harvard endowment were 8.9%—after the collapse and liquidity issue of 2008. The typical 60/40 portfolio returned just 1.4% per annum over the same time frame.

Unsurprisingly, others wish to emulate such success. What is at issue, however, is how to execute such a strategy at more moderately sized funds. The Harvard Management Company’s endowment staff numbers near 150, a figure unimaginable at an endowment of $5 billion or lower. Even Yale, which limits its staff by outsourcing its management, has upward of 20 people pursuing due diligence and research. The result: outsourcing.

“A lot of people want to use the university endowment model,” says Joseph Gelly, Investment Outsourcing Practice Leader at Russell Investments. “Unfortunately, many small to midsize organizations don’t have the scale or investment expertise to do so. It takes resources to implement such a solution internally, and below a certain asset size”—this sweet spot is pinpointed by numerous parties at anywhere below $1.5 billion—“it usually is not feasible without outsourcing.”

Cambridge Associates CEO Sandy Urie agrees and expands on the idea by noting that the increasing complexity of endowment management in general, including endowment models employing a high-equity and diversified-equity approach with an allocation to alternatives, requires more intensive day-to-day oversight and a depth and breadth of research and due diligence. “The results of 2008 showed us the complexity of this management style,” Urie says. “Endowment fiduciaries need a full understanding of how the endowment fund functions within the overall financial structure of the organization and what that means in terms of risk management and liquidity requirements. It’s important for endowments to have more than just the expertise to invest in alternatives. They need to focus on risk management and also on ensuring there is the necessary liquidity.”

Indeed, cash squeezes occur anywhere money is managed, as was made painfully apparent throughout financial markets in 2008. One prominent case in the outsourcing space is that of Commonfund, the nonprofit money manager, which limited withdrawals from two funds in September and October of 2008 following concerns that investors would pull money from the short-term portfolios that housed institutional cash. Another widely reported example was Harvard—which is well-known to run a hybrid model—which experienced a challenging squeeze on its positions, resulting in a bond issuance and a failed attempt to sell private equity commitments in the secondary markets. An absence of liquidity concerns, surely, is not synonymous with outsourcing.

One further issue that Urie points to is a physical reality that often is missed in the theoretical discussion of outsourcing: the geographic remoteness of some endowment and pension funds. “One of our advisory clients said ‘What I like is the flexible nature of outsourcing’,” she says. “He was saying that to attract and retain talent is difficult. It could take six to 12 months to replace a key person in certain cities but, when it’s outsourced, investment office providers have a deep bench of talent from which to fill the necessary positions on the team.”

Yet, despite the seeming clarity of such benefits, the actual decision point regarding outsourcing can be inhibited by the internal politics of a nonprofit’s board. “The issue with endowments and foundations isn’t so much whether to outsource robustly or use a sleeve approach,” says Northern Trust’s Campbell. “It’s whether the board is really ready to surrender control.” Unlike the aforementioned pension board, nonprofit boards are often the domain of large donors who—almost by definition—are wealthy and well-connected. Their goal is not so much risk reduction, but to aid the institution through their often vast knowledge of the investment space. Ceding control over manager selection can often seem anathema to such motives.

Back where America’s Great Plains meet I its Rocky Mountains, the University of ‘Colorado awaits the anniversary of its outsourcing decision. A middling equity market will have tempered its annual return but, if this figure approximates or exceeds the commonly quoted NACUBO average, the move likely will be left free of criticism regarding the questionable circumstances in which it was made.

The Colorado story, then, is indicative of a larger theme of investment management outsourcing, both at nonprofits and pension funds. There are potential drawbacks: Some are of a fund’s own making (Bittman’s conflict, for one), and some are inherent to the business (control and transparency issues). Yet, if such risks are acknowledged and managed wisely, the result can be a wildly positive one.

However, what if performance begins to falter? “If returns started to reverse themselves, I could see this trend slowing,” says Cambridge Associates’ Urie, “but I don’t see that happening as portfolios are likely to remain complex and increasingly global. This idea, done for the right reasons, for the right fund, just makes such sense.” While the “right reasons” differ by fund type, the end result is the same: professional investment management, customized to an institution’s needs, providing cost savings. Even the University of Colorado and Christopher Bittman’s harshest critics would be hard-pressed to argue with that.