A $250 million foundation had been working with a $300 billion outsourced investment manager for several years. The foundation’s new investment committee chairman found it difficult to discern how the organization’s investment performance was really stacking up. The quarterly reporting compared performance to a “custom benchmark” comprised of ten separate indices, including such esoteric ones as the “ICE Bank of America Merrill Lynch Developed Markets High Yield Constrained Index USD Hedged Index.”
The committee and staff were left scratching their heads as to whether their Outsourced Chief Investment Office (“OCIO”) partner was under- or outperforming the market. A quick analysis compared to an appropriate broad market benchmark like the 60% MSCI All Country World Index/40% Bloomberg Barclays Global Aggregate Index confirmed persistent disappointing results.
Without appropriate benchmarks and transparency, it is impossible for an investment committee to carry out its essential function of monitoring the performance of its OCIO partner and the portfolio’s underlying investment managers. Investment committees should be able to readily compare the overall portfolio, major asset classes and individual manager strategies each to their corresponding widely recognized benchmarks so that performance enhancers and detractors can be easily understood.
Too many consulting firms, large OCIO outfits and wire house banks have gotten into the habit of slicing and dicing benchmarks to the point that their comparisons cloud results rather than shedding light. Furthermore, the tendency to then “hug” these contrived benchmarks practically guarantees long term underperformance to broader, less constrained options.
Proper benchmarking is not just essential for performance monitoring, it is also critical for analyzing risk and predicted returns. In the case of the foundation, not only did actual returns lag, but the portfolio’s overly complicated asset allocation was set up to take on greater expected volatility and more risk (as indicated by its Sharpe Ratio) compared to a broader, more streamlined allocation such as the 60% ACWI/40% Global Agg benchmark mentioned above or another broad mix such as 70% ACWI/15% Global Agg/15% HFRI Global Hedge Fund Index. Becoming fixated on elaborate custom benchmarks often distracts investors from their primary purpose of achieving the organization’s long term financial objectives and glosses over potential opportunity costs forgone by not investing in a more streamlined, transparent, liquid and cost-effective asset allocation.
An additional issue relating to transparency was hampering performance and clear, concise reporting. As with many large providers, their size dictates the necessity of economies of scale over customization. Their solutions often include asset class “sleaves” or “building blocks” comprised of a black box of managers and strategies. In the foundation’s case, their OCIO provider invested in a multi-asset class fund comprised of 26 managers in 12 different sub-asset classes, including de minimis allocations to Japanese Equity, Global Infrastructure and Bank Loans. This was not just an example of over-diversification or what we sometimes call “deworsification”, but also made it impossible for the committee to understand the drivers of performance and the level and location of risk in the foundation’s portfolio.
Asset allocations and benchmarks should be as simple and clear as possible in achieving the client’s long term financial goals. Overly complex asset allocations and convoluted benchmarks reduce the investment committee’s ability to carry out its mission and lower the chances of long term portfolio success.
The investment committee decided during a careful review process of its financial objectives and their codification in a re-written Investment Policy Statement that a straightforward benchmark of 70% ACWI/30% US Agg made the most sense for the organization. As a result, a new custom asset allocation and manager line-up was created to achieve the stated goals and to be appropriately positioned to outperform the benchmark over market cycles.
