Category: Briefings

OCIOs vs The Magnificent Seven

Posted on by Chris in Briefings

You May be in VC but not know it: OCIOs versus “The Magnificent Seven”

While OCIOs performed well in 2023 overall, within their public equity allocations few OCIOs successfully positioned themselves to take advantage of key equity market dynamics of 2023.  This briefing examines the reasons why that was the case.  In particular, we look at the impact that the “Magnificent Seven” performance phenomenon had on OCIO performance, and the stealth “megacap venture” allocations that have been growing in institutional portfolios.

The Year of “Negative Alpha” In Public Equities 

Across the 50+ OCIOs that we monitor, we have seen many cases of strong alternatives performance, yet we have not found an OCIO that exhibited meaningfully positive alpha in their public equity allocations in 2023.  Several OCIOs described the 2023 experience, where gains from the top seven market cap companies [the “Magnificent Seven”] exceeded the gains for the entirety of the rest of the S&P 500, as a “more than three standard deviation event.”  They believe equity markets are primed to mean-revert, that is, returns on the rest of the stock market will catch up to the Magnificent Seven returns, or that Magnificent Seven valuations will fall back in line with market norms. 

We approach this “mean reversion” line of thinking with a note of caution.  It sounds similar to other mean-reversion themes over the last 10 years: for value stock performance to catch up to growth stock performance, or for European equities performance to catch up with U.S. equities performance.  In both instances, there has yet to result in a meaningful catch-up of value or performance relative to U.S. growth and U.S. broad market index performance.

The Magnificent Seven

The impact of the performance of the Magnificent Seven on OCIOs’ 2023 equity performance should not be overlooked.  You have probably seen this performance data for 2023 but it is worth revisiting:

Magnificent Seven Average: up 111%

S&P 500 Capitalization Weighted: up 24%

S&P 500 Equal Weighted:  up 11%

MSCI ACWI: up 20%

The very large difference between the capitalization weighted and equal weighted gains reflects both the large Magnificent Seven returns, and the now-29% share of the S&P 500 that the Magnificent Seven represent. The 13% gap between the equal weighted and capitalization weighted returns means that your experience seeking alpha in public equity markets depended almost entirely on the extent of your allocation in the seven largest megacap stocks last year.  If your OCIO’s strategy is to find talented public equity managers who pursue unusual sources of alpha in overlooked investment themes, your OCIO has probably significantly underweighted the Magnificent Seven megacap stocks.  Thus, your public equity return might be somewhere closer to the 11% equal-weighted gain than the 24% market cap-weighted gain.  If your OCIO mostly allocated public equities to indexes, or was careful to align your underlying stockholdings’ weights with the market capitalization weights, your public equity returns were probably closer to the 24% return. 

Investors fall in and out of love with specific assets over time and you likely have heard of the nifty fifty, Tech Bubble, etc. over the years.  The Magnificent Seven are viewed as a group much like the old FAANG stocks of only a few years ago.  (Facebook (now Meta), Apple, Amazon, Netflix, Google (now Alphabet).)    The change from FAANG to the Magnificent Seven is the addition of Microsoft, Nvidia and Tesla, and dropping of Netflix. The incessant AI chatter and hopes are tempting investors that the megacap outperformance will continue.

So are the Magnificent Seven a fad that will mean-revert, or is something else going on?

An Alternative View: Are the Magnificent Seven the Premiere Venture Investors?

While we are familiar with macroeconomic debates about monetary policy, a key interest of macroeconomists has been identifying the reasons for economic growth.  Technological advancement is viewed as a major driver in macroeconomic models, and the United States’ private sector has been a major contributor to economic growth by investing heavily in research and development (R&D).  As investors, we think of venture capital as a major area of technological evolution, but since we are more aligned with allocators, not stock analysts, we can easily overlook the extent of technology investing derived from publicly-held companies.  Let the data do the talking: 

Sources: market cap and 2023 % Gain are from multiple market data sources; R&D figures are from annualization of third quarter R&D spending from third quarter financial disclosures of each company, total commitments to venture capital funds by year provided by Pitchbook.

Notes: Amazon does not break out research and development (R&D) expenses from spending on all technology and infrastructure. 

Clearly we are equating venture investing with R&D investing, yet we accept this linkage as being very close, since almost all R&D spending by these companies will be invested either in developing new technologies or finding new applications for existing technologies.  That’s pretty much what almost all venture capital managers seek to do. 

From the data, we can see that the Magnificent Seven’s R&D budgets far outstrip the R&D budgets of the venture capital industry in 2023.  Recognizing that 2023 was a weak year for venture fundraising, we thought it important to compare as well to venture’s peak fundraising year of 2021. Even then, the entirety of the venture capital industry likely just barely kept up with the R&D spending of the Magnificent Seven.

Are Magnificent Seven Investors Unknowingly the Biggest Venture Investors?

So the Magnificent Seven are big R&D spenders, but how much of an investment in these companies is really a venture-like investment?  Each firm already has a well-defined source of cash generation from their ongoing businesses, after all.  A quick look at their financials shows that R&D spending represents about 10 to 25% of these companies’ revenues, and 25% to 100% of their profits, in the third quarter of 2023.  Those are big commitments! 

We would argue that the outstanding returns of the Magnificent Seven represent the result of many years, even decades, of venture program-like investing.  Most recently, cloud computing and storage have brought major new business lines to Microsoft and Amazon, with others trying to catch up.  In fact, cloud computing, a business that barely existing 10 years ago, represents the majority Amazon’s revenues now.  AI opens the potential for vast new markets and could stimulate more technological advancements in sciences, law, education, medicine, and other areas, though it is possible that the value from AI accrues almost entirely to clients rather than the producers. 

The net result is that investing in the Magnificent Seven may be like investing in a blend of mature businesses alongside well-established and successful venture investing programs.  While determining the mix between the two may be beyond the scope of this discussion, such considerations haven’t stopped us from positing a rule of thumb: if company management is spending 25% to 50% of profits on R&D, then what is the venture mix of an investment in that firm? Is it close to that profit share (we’ll just refer to this as “megacap venture”).  Moreover, since the Magnificent Seven represent about 29% of the S&P 500, does that mean that institutional investors’ indexed U.S. public equity allocations are implicitly 7 to 15% invested in venture?  After adjusting for non-U.S. holdings in equities, that would be an “average” global equity investor is 5 to 10% invested in “megacap venture.”

You may already be a substantial venture investor through your indirect “megacap venture” allocation, even if you do not have a formal venture allocation.

Venture Investing and Volatility

Experienced alternatives allocators have many stories to share about volatility in their investment strategies, and no major group of alternatives investments is riskier than venture investing.  Some of that riskiness clearly shows up in the volatility of the megacap stocks.  However, the operational aspects of R&D investing in a corporate framework are quite different from within a venture-backed startup’s framework.  Incentives to venture founders are exceptionally strong.  Conversely, oversight by talented project managers in a proper corporate setting may allow for a more efficient allocation of resources among R&D efforts, both to deploy capital and to cease investments in less promising ventures.

Reconciling the Megacap Venture Experience with our OCIO’s Allocations

Here we face the crux of the problem.  If an alpha-seeking allocator will look for equity managers with an “edge” for investing in or trading stocks that will inevitably scan the universe broadly for best ideas, the result for 2023 will be greatly reduced allocations to the top-performers, the Magnificent Seven.  That allocator will likely see a substantially negative alpha in their liquid equities allocations, despite the talents of their underlying equity managers.

However, looking at a partial picture can be misleading.  Many OCIOs are keenly aware that private equity, growth equity, and venture capital investment programs are inherently turbocharged growth equity allocations over the long term, so they tend to hold value biases in their liquid equity portfolios to create a more balanced growth/value portfolio.  In other words, if your OCIO has been investing in venture and growth equity strategies, it is likely that you will have positive experiences in your private holdings offsetting the lagging performance in the public equity portfolio over the long term.

Conclusion #1: Don’t Expect Mean Reversion, Megacap Venture-Like Investments Have Succeeded

We see a permanent change in the U.S. public equities market structure.  Technological innovation appears to favor very large companies, rather than large numbers of small companies.  Now we are projecting outside our core expertise by pretending we are stock analysts, but we’ll share our perspective on the seven companies.  Unlike in prior “tech bubbles,” the tech giants [MSFT, AAPL, GOOG, AMZN, FB] possess true “know how” that is difficult to replicate, defended by myriad patents, and fortified by continuing research. We see an oligopolistic market structure, with wide profit margins and stable to expanding market share, as a long-term structural change in the public equity market that will continue to flummox the talented alpha seekers.  We also see these vast businesses as exceptionally difficult ones for equity managers to understand at a level where they have a material “edge” over the market.  The net result is that about 25% of the public equity market represented by these five stocks is both critical to asset allocators and opaque to alpha-seekers. 

We also believe that TSLA and NVDA, both excellent firms, face greater risks in their more-concentrated business models; TSLA because they face rising competition from auto manufacturers entering the EV market and waning EV market growth, and NVDA simply because their already-high valuation implicitly depends on programmers failing to increase the efficiency of large language models and other AI programs by 90%+ [which is believed possible], and the failure of meaningful competition to arise over the next few years. The great stock pickers can hopefully discern better than we can how material these risks are to TSLA and NVDA.

The net result: generating alpha from large and megacap public equity allocations is harder than ever, and under allocating to megacaps likely means under allocating to some of the U.S. economy’s greatest economic growth engines.

Conclusion #2: What We Would Like Every OCIO to Consider

As search and evaluation consultants, we are pleased that the impressive array of OCIO managers we recommend continues to produce returns for their clients meaningfully above OCIO market benchmarks. These OCIOs have created a culture of excellence that extends throughout their investment process, and they often achieve their greatest alpha-generating successes with their alternative investment programs. 

While OCIOs also strive to generate alpha with their selection of public equity managers, now may finally be a time of reckoning.  Finding alpha investing in large cap equities is exceedingly difficult, and we rarely see active managers [or hedge funds, for that matter] who have truly demonstrated an edge in analyzing megacap stocks.  Conversely, equity managers that focus on stocks that they can analyze with some edge will likely be underallocating your capital to megacap stocks, leaving you underweighted to that critical growth engine, “megacap venture.”

We ask our talented OCIO managers to consider [again] the possibility that increased use of indexing in the large and megacap parts of the public equity markets may actually be desirable, unless the OCIO has rare capacity with the very short list of alpha-generators in large cap markets.  OCIOs need not prove they produce alpha everywhere, and it is better to concentrate efforts where they have demonstrated a meaningful advantage.

We would be pleased to discuss this topic further, and to hear any feedback or experiences you may wish to share with us.  We can be reached at 917-287-9551 or at info@manageranalysis.com.

Manager Analysis Services LLC

February 1, 2024

Can OCIO Evaluations Be “Free?”  Benefits of Reviewing Your OCIO Over a Full Market Cycle 

Posted on by Chris in Briefings

In addition to conducting OCIO searches, we also evaluate OCIOs for clients that want a “wellness check” on their OCIO relationships.  These clients find our OCIO evaluations informative and helpful, and thankfully, for the most part clients find that they remain satisfied overall with their current OCIO provider. One area that clients find particularly enlightening is having their OCIO advisory fees “marked to market,” particularly where reviews have not been conducted for more than four years.  Potential fee savings are often a multiple of the cost of an OCIO review. This can essentially make the evaluation “free” and result in an annual saving to the client. Review of an OCIO over a Full Market Cycle aligns with the industry practice of reviewing any investment manager performance over a market cycle.

Here are other common themes found in our OCIO reviews:

  • Conflict of interest from OCIO Self-Evaluation: Many OCIO clients excessively rely on their own OCIOs to self-evaluate their performance. We see many cases of OCIOs reporting their performance in the best light, and not comparing themselves to appropriate peer groups.  This practice occurs because evaluating OCIOs requires specific resources and expertise that often is hard for OCIO clients to access internally. Our evaluation service closes this gap.
  • OCIO Performance Evaluation:  Particularly over the last three years, some OCIOs have experienced substantial negative alpha on their liquid, actively managed equity strategies.   Often more than offsetting that negative alpha has been strong performance in private equity investments.  We can help you ascertain whether the recent record of negative alpha in equity strategies is a warning sign, or is a reflection of temporary market conditions.  We can also help you evaluate the quality and scope of your OCIO’s private investments program.
  • OCIO Alternative Investments Success Evaluation: Almost all OCIOs have embraced private investment strategies for a portion of their clients’ portfolios.  However, some OCIOs have moved very quickly into private investment strategies, and some may not have built out experienced diligence teams nor developed robust investment premises behind their private investment programs.  This development could be a material risk to you, because the long-term nature of private investments means that you are “stuck” with any errors made for a 5 to 10 year horizon.  We are experts at evaluating private investment strategies, so we can help you calibrate your OCIO’s strengths in private investment strategies.

We would welcome a conversation to show how we can help your specific situation during which we would be pleased to share a sample OCIO Evaluation Report with you.

Since 2003, Manager Analysis has provided investment research and support for clients.  All 3 principals each have 30+ years investment expertise, including having led 3 different private foundations and having served on 11 different Boards. 

We can be reached at 917-287-9551 and at cutler@manageranalysis.com.

Are Today’s Private Equity Market Challenges Signaling a Shift Back into Public Equities?

Posted on by Chris in Briefings

Our team of experienced investment consultants at Manager Analysis Services analyzes over 50+ OCIOs for our Outsourced CIO Search and Evaluation services.   Private Equity’s (PE) ever-growing share in investors’ portfolios provided a catalyst to ask our OCIO relationships what they are seeing currently.  We also have reviewed over 2,000 alternatives managers and we recall a particular review, where a specific manager asserted to have “unlocked the secrets” of private equity performance.  Moreover, the manager claimed he could exceed private equity performance using a quantitative small/microcap public equities strategy. 

It sure would be nice if this manager’s thesis worked. Investors would have short-term liquidity, rather than face 10-year capital commitments with high fees.  Perhaps most compelling would be that small and microcap companies could remain part of the “open and democratic” public markets…one share, one vote…which we would strongly prefer over the current trend of private equity funds subsuming all of microcap into their orbit.

What Are OCIOs Seeing in Private Equity Markets Today?

There is no shortage of challenges in private equity markets today.  Private Equity fund raising in 2022 was off nearly 40%, and about 75% in the first quarter of 2023, according to Pitchbook data.  The biggest drop has been in Asia with China concerns leading to a decline of nearly 2/3rds in 2022, and near zero fundraising so far in 2023.  Concomitant with the decline in fundraising has been a decline in distributions from seasoned private equity funds.  Weak public equity markets have slowed the path for private equity fund managers seeking liquidity from IPOs, or acquisitions of their holdings by larger, publicly traded companies.  The net result is that the size of the private equity market has not really decreased much from the slowdown in fundraising, and asset owners’ private equity portfolios have experienced decreased turnover.

Private equity valuations have been relatively resilient, but experience demonstrates that private equity valuations tend to lag public market valuations by 6 to 12 months.  The public markets’ sharp declines in 2022 caused large PE investors to become overweight (on an allocated basis), and many have reduced or paused additional monies to private equity. 

Bright spots and New Opportunities:

In our conversations with OCIO managers, we have heard that:

– The “denominator effect”:  Is not impacting all investors.  Some have responded by raising their private equity allocation percentages so they could continue their programmatic allocations to private equity managers.  Most OCIOs are not concerned about having to raise this allocation percentage, and they encourage investors to sustain their pace of investing in PE to ensure a diversification of vintage years.

– Price Outlook: OCIOs expect more markdowns.  With respect to most private equity strategies, markdowns will not be as bad as feared, nor as bad as public equity market declines.  Late-stage, venture capital strategies do remain a big area of concern, because those strategies often depend on public market IPOs or buyouts by public companies to provide exits.

– Size: Large, established PE managers are currently more willing to accommodate smaller LPs.

– Fund Sources: Secondary and continuation fund opportunities have grown, offering liquidity to LPs who are overallocated to PE, and interesting opportunities to investors who understand the secondaries markets.

– Financing: Growth opportunities are more appealing; buyout funds are facing much higher financing costs.

Private Equity vs. Public Equity

So why do so many OCIOs like PE?  Do PE strategies outperform public equities, and if so, why?

A quick look at the most recently available Pitchbook data on private equity performance shows the average private equity fund over the 10 years to September 30, 2022 returned an 18% IRR, compared to about 12% for the S&P 600 small cap index, when including dividends.  Private Equity funds in the smallest size category materially underperformed but still beat the 12% return of small caps.  Overall private equity fund returns beat every major public equity benchmark over the last 10 years ending September 30, 2022.

While PE managers excel at explaining why they “outperform,” let’s take a look at the converse: reasons why their public market-equivalents, microcaps and small caps, tend to underperform private markets.

The Long-Term Assault on Public Equity Markets

American regulators have a practice of creating layers of complexity in reaction to crises, rather than designing and implementing sensible regulatory processes. The US should revisit the regulatory structure for smaller equity issuers, and it should be re-engineered to reflect how smaller public firms can function in a sensible way.

Here are some of the myriad challenges of being a smaller public company, and in some of these cases sensible regulatory reforms could be a big help:

i) High Fixed Costs for Being Public: Not all of our readers may remember the Enron and WorldCom frauds, where both large-cap companies materially exaggerated the scope and profitability of their businesses, yet had a then-big five auditor, Arthur Anderson, conduct and sign off on their audits.  Congress’ response was to pass the Sarbanes-Oxley Act [“SOX”], effective in 2003, which created extensive control and testing requirements for publicly traded companies.  While the desire for better controls was certainly understandable, SOX reflected regulators’ pattern of throwing additional regulatory burdens on commerce, rather than offering a well-conceived approach to constructing a rational and efficient regulator process.

SOX was a boon to the auditing community, creating an additional ~$1 million in financial statement preparation expenses for every small public company, which posed a heavy burden particularly on microcap companies.  Additionally, companies’ CFOs would also be held personally liable for misstatements.  The line by which executives could be held personally liable was never very clear, further raising the implicit costs of being a public company. 

ii) Scarce Analyst Coverage for Small cap Companies: Small Cap and Microcap executives’ committed substantial energy towards attracting interest from stock analysts and investors.  A common thread was that, by not locating sufficient long-term investors who were committed to their investments, the stock price would decline sharply just from lack of focus or interest. Such a decline could render the company vulnerable to activists or takeovers at depressed valuations.

iii) Availability of Growth Equity Capital: If a public company wants to make new investments or acquisitions that require substantial amounts of fresh capital, the company is dependent both on current equity market conditions and market perceptions of it.  This contrasts with being able to rely on the perceptions of a smaller set of long-term PE investors who would likely be more receptive to their business plan.

iv) Insider Trading: One way to attract investor interest is to speak with investors about the company’s activities.  Some investors would push the limit of these discussions and seek tips or induce a flow of information that would favor their position over other investors with inside information. 

v) Market Manipulation around Critical Corporate Events: This topic is too extensive to cover in a briefing, but let’s consider an example of an eminently sensible merger, where Company A is buying Company B at a 50% premium to its stock price and there are no other bidders.  The merger arb managers have bought up as much of Company B stock as they can, and it now trades at only a 3% discount to the agreed-upon merger price.  To everyone’s surprise, Company B shareholders voted down the merger!  How could that happen? 

Stock lending desks can sometimes not be careful about who is borrowing the vast amounts of shares available to borrow from institutional custody accounts. Some hedge funds have been known to borrow this stock around the date of record for voting for mergers, while discretely shorting the stock synthetically with over-the-counter swaps.  The net result is that the hedge fund had the full voting power of a large shareholder while being heavily short the stock. The hedge fund would induce a sensible merger to fail, and reap outsized profits at the expense of all stakeholders involved.

Risks around the stock-lending process are material, and they are also such a technical niche that corporate management teams, busily focusing on running businesses, are often not prepared for surprises from the stock loan market.

vi) Activist Demands to Pursue Short-Term Gains: To be clear, we like constructive activism, but we are also aware that some activists press companies to make short-term moves that could be viewed as contrary to long-term commitments to a business. We take particular note of news regarding Icahn’s IEP, where this activist seems to be better at extracting short-term gains than actually managing a portfolio of profitable enterprises.

Having analyzed the challenges Small Cap public companies face, let’s look at how Private Equity Markets counteract these challenges and provide investors with an opportunity to consider these markets.

Advantages Offered by Private Equity Markets

Private Equity markets offer Small Cap companies solutions for each of these challenges:

  Public Company Challenge  Private Equity Solution
i) High Fixed Cost for Being PublicPrivate companies face greatly reduced regulatory costs.
ii) Scarce Coverage for Small Cap CompaniesPrivate companies can focus on relationships with a much smaller number of private equity managers that specialize in their markets.  
iii) Availability of Growth Equity CapitalPE managers are receptive to requests for growth capital because they understand companies’ businesses and recognize opportunities.  
iv) Insider Trading RisksGenerally not relevant, although investors should be cognizant that “continuation fund” offerings can create conflicts of interest between investors seeing their capital being returned at the end of a PE fund’s life, and the general partner seeking to start a new investment vehicle with a lowered high-water mark.  
v) Market Manipulation Around Critical Corporate EventsThe technicalities of stock loan markets are not relevant for private companies.  However, private equity investors should understand, analyze, and value any “consulting” or “advisory” agreements between portfolio companies and PE GPs.  
vi) Activist Demands to Pursue Short-Term GainsPE managers are heavily incentivized to produce the best long-term returns for investors and can do so by ensuring high quality management teams manage portfolio companies.  

Given the many advantages for companies to be privately held, it should be no surprise to see private equity markets continue to grow.  Currently the combined U.S. private equity/venture capital market is about $4.5 trillion.  Private real estate, private credit, and private infrastructure represent another $2.3 trillion of private markets.  In comparison, U.S. public equity markets are about $51 trillion in size.  We view some of the real estate and infrastructure investments as comparable to private equity strategies, and we assess the private equity share of the combined U.S. equity markets as being about 10%. 

What should this 10%-share-of-equity-markets mean to institutional investors? 

At a minimum, those overlooking this “10%-of-equities” allocation have incomplete portfolios, and they are missing the interesting growth and innovation that historically derives from small and microcap companies.  To achieve that allocation, we strongly believe that institutional investors need to develop their PE investing capabilities if they do not already have them. 

What about the manager who asserted to have “unlocked the secrets” behind private equity returns, using a quantitative public market strategy? 

After about four additional years of performance from this manager, the public markets, and the private markets, the results have been telling.  Recalling that the average private equity fund over the 10 years to September 30, 2022 returned an 18% IRR, compared to about 12% for the S&P 600 Small Cap index when including dividends, this manager’s performance has been materially below the S&P 600 small cap index.  They marketed a compelling thesis and raised over $500 million, subject to long-term lockups despite the strategy’s relatively liquid holdings allowing much better redemption terms.  Moreover, they had outstanding references from notable leaders in the asset management industry.

Why did we recommend the client not invest? 

Aside from having unnecessary investor lockups for a small manager in public markets, our concerns were as follows: poor investment thesis through their weak understanding of the PE markets, the convenient omission of the strategy’s poor first year performance from marketing materials, a weak back-testing methodology, flaws in the implementation process, and lack of a sufficiently deep industry experience.  We certainly have nothing bad to say about the principals of this manager, but we are pleased to have had the opportunity to redirect our client’s capital to more profitable investments.

Conclusion

We have yet to experience an OCIO manager tell us that the recent challenges in PE markets have caused them to reconsider or reduce their PE allocations in favor of any other asset class.  Rather, they see Private Equity continuing to provide an attractive alpha opportunity while diversifying risk in a portfolio:

  • Typical OCIO allocations are to be in the 10 – 12% range of equity allocation, and that share continues to grow. 
  • OCIOs that strongly embrace private markets have private allocations ranging from 25% to 40% where client liquidity profiles allow.
  • OCIOs encourage clients to maintain their rate of commitments to PE funds despite 2022 performance and the recent slowdown in PE activity.
  • 10 Year PE year returns of 18% are better than both S&P 600 Small Cap Index returns of 12% and other broad equity market indexes.
  • PE-owned companies can be better managed, or more inexpensively managed, than public small companies, as they are not subjected to many challenges that public-listed companies face. PE-owned companies have managers that can focus almost exclusively on the direction of their core businesses.
  • Any indexing effort to achieve a truly representative allocation to broad equity markets is incomplete if it does not find a vehicle to include a 10% allocation to private equities.

Therefore, we believe that current challenges faced by PE Markets are not signaling any shift into Public Equities. Instead, we see PE markets continuing to take a growing market share within the Small Cap equity markets.

Should you wish to have a complimentary discussion of your private equity investment program, or your OCIO’s investment performance, you can reach us at 917-287-9551, or at cutler@manageranalysis.com. 

Manager Analysis Services performs diligence specifically on Private Equity, Venture Capital, and Hedge Fund Managers for investors.  We have analyzed over 2,000 funds since our founding in 2003 and we are fully independent.  We also offer Outsourced CIO evaluations and searches for Pensions, Endowments, and Foundations. Our 3 Senior Principals have a combined 90+ years in Investments, Diligence, and Risk Management.    

Terrible OCIO Performance Merits Your Attention

Posted on by Chris in Briefings

Many fiduciaries have been challenged by their OCIO’s performance this year, and question whether their OCIO’s performance is acceptable in light of terrible market performance [S&P 500 down 14% plus and bonds down 10% to 15%]. Returns are actually worse after considering 8% inflation, and many fiduciaries are finding that the actual buying-power is down over 20% in
real terms.

What steps should you take that properly support your decision to retain your OCIO, or to explore whether you should search for a better-performing OCIO relationship? We suggest that a first step is to consider whether your OCIO is performing satisfactorily, relative to market conditions, to help inform your governance efforts:

Market returns have been exceptionally poor 2022 YTD. This year is only the third year since 1900 when both equities and bonds indices were both down. (2015 and 2018 were the other two years.) Indeed all 11 S&P sectors suffered with the notable exception of energy (+34.5%). Certain alternative funds provided effective diversification. Those OCIO managers that were sufficiently nimble to layer in protective equity puts, pivot to energy, avoid long duration fixed income, and focus on specialized hedge strategies were best able to reduce overall market losses. It is these types of OCIO managers who are the standouts.

Conversely, we have seen OCIOs underperform from several causes. OCIOs that pursued 60/40 allocations that did not dodge rising interest rates’ impact on their bond portfolios received a double hit. OCIOs that focus on “alpha creators” for their long only equity managers [an allocation approach we meet with great skepticism] also were hit hard by the fact that those OCIOs really didn’t diversify by style, and many of their managers are growth-and-tech bias at the epicenter of underperformance in year’s value-oriented equity market. OCIOs with a strong “geographic diversification” [i.e. underweight in the US markets] were hit by falling European currencies and weak European equity markets. Finally OCIOs that tend to use equity-oriented hedge funds missed the benefits of having the full suite of hedge fund strategies.

Whether you wish to continue your OCIO relationship or are considering a search potentially to replace your OCIO, we recommend that, as fiduciaries, you evidence that you have reviewed your relationship if you have had losses near or over 15% this year. We specialize in evaluating OCIO portfolio performance and can assist you in providing an objective third party analysis. Manager Analysis Services has nearly 20 years’ experience in this field. We offer your fiduciaries a complimentary discussion of your OCIO’s performance, and whether you should take further steps.

We welcome your call at 917-287-9551.

Borrowing Opportunities for an Endowment or Foundation

Posted on by Chris in Briefings

Borrowing can be used for offensive as well as defensive purposes. Typically, it takes the form of a Letter of Credit or borrowing under a Securities Lending Agreement.

Research has shown that Endowments will often use lines of credit offensively to fund private equity capital calls. It enables better cash management and investment timing. Smaller Foundations tend to use lines of credit for that same purpose. Foundations also use Securities Lending defensively to avoid selling “underwater” equity positions to fund current grantmaking. This can make sense if the Foundation views itself as a perpetual investor and the equity sell-off is considered a temporary or short-lived phenomenon. (One should ensure that the Foundation’s governing documents either enable or do not preclude borrowing.)

Lines of Credit – Typically arranged with a bank and often is uncollateralized.

Securities Lending – Collateralized borrowing is an active part of the financial markets and many market players engage in this type of lending to boost returns.

We envision Securities Lending as a defensive means for Foundations or Endowments to avoid selling “underwater” equity positions, rather than “locking in” a loss. Securities Lending agreements are highly standardized and sample templates are available on the Internet. (You should of course use your own legal counsel) but the internet documents do provide the reader with a sense of the wide use and standardization that exists.

Goal – If the entity has a perpetual time horizon and believes that the equity markets typically rebound within a 2- or 3-year future time horizon, borrowing may make long term sense.

Collateral – Typically one would pledge securities that would be placed with a custodian. (Securities may need to be “aged”, i.e. fully paid for and have been held for a minimum time period, e.g. 1 month, prior to pledging.) The advance rates would be based on the specific assets pledged. Typically, the rate would be Libor + a spread.

Want to learn more? Please contact Chris Cutler or Tom Donahoe

The 7 Steps to Selecting an OCIO

Posted on by Chris in Briefings

We have led OCIO searches and selected providers as well as analyzed many additional completed OCIO searches. We’ve distilled the process down to 7 key steps. They are as follows:

CATALYST – There are typically specific concerns that trigger a search: performance, portfolio concentration, liquidity, poor service, and/or fees. Survey participants often tick the box as “fees.” While often true, we believe that “fees” may often be a stalking horse that provides cover for other motivating rationales.

AWARENESS – The Investment Committee or Board needs to educate themselves as to what’s available in the market. This takes time and direct interaction between providers and Board/IC. Internal staff is often understaffed and is not able to distill the information on a timely basis. (Surveys show internal investment staff to be 0.5 FTE or less.) Moreover, staff members may wear multiple hats and investing oversight may be hampered by manual processes.

GOAL(S) – Investment Committee members should agree on a clear articulation of the organization’s goals. If this is left vague or allows late-entrants into the bidding process, it will reduce the efficiency and transparency of decision making.

IDENTIFYING ELIGIBLE OCIO PROVIDERS – This requires someone with industry expertise, time in markets, and understanding of client’s needs and goals.

REQUEST FOR INFO – This should precede a formal RFP. It is a list of 5 to 7 key questions that are submitted to a larger, potential universe of OCIO providers. This enables you to surface issues (conflicts) early, review each submission on a conference call with the provider (and get a feel for working with that team.) You then go out with a formal RFP to a distilled subset of your RFI respondents.

INTERVIEW – This is essentially a semi-finalist stage. Then, there should be an on-site visit at the provider’s place of business once you are down to the finalists.

DECISION – Always have a first choice and a back-up, in case the first choice does not result in a final agreement. Entire search process is typically 3-4 months.

Want to learn more? Please contact Chris Cutler or Tom Donahoe.

Governance – Using Progressive Term Limits and the Emeritus Issue

Posted on by Chris in Briefings

Trustees are a great asset, provided you select and support them diligently.

The governance structure of non-profits tends to be the mirror opposite of for-profit organizations. It is a simple reality that those long-term board directors in non-profit institutions usually shape the policies and direction of their organizations. Having an effective governance strategy for selecting and rotating board governors is a great way to ensure that the non-profit institution has the right set of committed and unconflicted talent serving as directors.

Typical TenorsFor-profit CompaniesNon-profit orgs
(Institutionalized)		Non-profit (founding
family-majority)
CEO tenure6 – 10 years10 – 20 years+20 years
Board tenure+20 years9 years (maximum)No real limit
N.B. – A non-profit Board is not considered “institutionalized” if the founders retain a Board majority.

Progressive term limits protect the institution:

Board member terms are best staggered, (similar to the US Senate, only 1/3rd of Trustees seats should become open each year.) This ensures stability and thoughtful transitions. Having three 3-year terms seems quite tidy but can make for an untidy mess. You expose yourself to “social loafing”, disruptive actions, and perhaps embrace too much risk with a new, untried Trustee.

As an alternative, one could implement progressive terms: initially 1Y term, then 2Y, and finally a 3Y term (you’ll know after 3 years if a director is good.) The rationale is that you could identify a new Trustee’s poor participation or lack of commitment early on, and this structure offers you a convenient (non-confrontational) way to limit damage to the institution. Also, try to avoid the romance of focusing only on the well-credentialed. You need to understand why a person is joining and if the new person also serves on another Board with one of your current Board members. This may result in a conflict.

A typical bylaw provision allows the “firing” of a Trustee at any time. In real life, most Boards simply plod ahead and refuse to face the friction of a contested exit that often requires near-unanimous agreement on ejecting a current director. A real-life anecdote is instructive. A Trustee missed 5 of 7 meetings and was considered “effectively” resigned. The Board woke up one day to a scathing press release that the Board member was “resigning in protest” about a sensitive issue.

Emeritus Status:

In a word, don’t! It’s better to have an annual dinner with current and past Trustees. Emeritus is an active designation and holders believe it confers power/access/voice in current decision-making. Emeritus may demand to see current minutes, etc. It is better to honor completed, past service. Moreover, ex-Trustees often simply want access to the library or email address. This can simply be approved by the Board and arranged by staff. Moreover, emeritus has often been given to large donors and this tends to annoy past Board members who served well but simply don’t have a thick wallet.

Want to learn more? Please contact Chris Cutler, Tom Donahoe, or Safia Mehta at 917-287-9551.

Ten Tips to Turbo-Charge Your Trustees to Max Performance

Posted on by Chris in Briefings

You’ll find below ten low cost, handy steps that can be implemented at your Foundation without spending Foundation resources.

  1. AN INDEPENDENT GUIDE TO TRUSTEE DUTIES – For onboarding new Trustees or ensuring that current Trustees fully understand or are refreshed in their duties; the NY Attorney General’s office publishes RIGHT FROM THE START and also INTERNAL CONTROLS AND FINANCIAL ACCOUNTABILITY. What better way than having a neutral, authoritative voice review the Duties of Care, Loyalty and Obedience in a clearly written dispassionate prose?
  2. START WITH THE TOUGH TOPICS – At Board or Committee Meetings, address the toughest topics first, do not let them hide deep in the agenda. Everyone is freshest and most alert at the beginning of the meeting. The priority topics will also ensure that Trustees join the meeting at the start. Ensure that there is a published time limit for each agenda topic.
  3. PROPOSED MOTIONS SHOULD BE DRAFTED IN ADVANCE – Draft proposed motions BEFORE the Trustee meeting. This ensures a thorough drafting, unrushed by time pressures. It also provides a document to speak to and use as a gauge. The meeting also does not devolve into a word-smithing exercise that eats up valuable Trustee time. If multiple motions are needed or pro- and con- motions, those also need to be shared with the Trustees before the meeting. (Ideally via a link to Cloud storage.)
  4. FUTURE TOPICS – Provide a list of planned topics on a rolling 3 quarters in advance so that Trustees know when major recurring topics will be addressed. They can also anticipate what projects might be helpful to align with the timing of future meetings.
  5. TIMELY SCHEDULING OF COMMITTEE MEETINGS – Require that periodic Committee meetings be scheduled at least ten days to 3 weeks before the actual Board meeting. This ensures that information distilled will be current and avoids a rush analysis in order to place items in the “Board Book” in preparation for an actual Board meeting.
  6. RECORD THE BOARD MEETINGS – It helps resolve disputes about what was said and ensures the accuracy and timeliness of the Board minutes, even if they are written weeks after the actual Board meeting. (Recordings can be deleted after one year or on a pre-agreed basis.)
  7. FOUNDATION EMAILS – Require all corporate information to be communicated on Foundation emails, which means that all Trustees are assigned foundation-domain email accounts. As a potential compromise, Trustees may continue to use their personal accounts, but ALL emails need to be cc’d to their foundation email accounts. (The latter is not best practice but may be a viable work around if not abused.)
  8. SOCIAL CAPITAL – All groups work best together if there is social capital built up. You should not solely rely on telephone meetings. There should be periodic meetings in person, even if only on an annual basis. The annual meeting or at least one meeting per year should be held at the site of the Foundation’s location or activities.
  9. INSURANCE – You absolutely need to review ALL your insurance coverage on an annual basis and in-depth. Risks and coverages change, and insurance gaps provide a potential for a major loss to a Foundation if not properly addressed. Trustees may want to focus on D & O coverage and be conversant with any “indemnity” coverages that the Foundation has agreed to provide, typically in its bylaws.
  10. CONFLICTS OF INTEREST POLICY– There are few topics other than conflicts that can cause as much damage to a Foundation, either reputationally or financially. With the Internet, scandal spreads quickly AND permanently. Your policy must allow for Audit Committee review, especially in a case of first impression. Avoid any appearance of conflict. An outside law/audit firm review could help.

Want to learn more?

Please contact Chris Cutler, Tom Donahoe or Safia Mehta at 917 287 9551.

The 3Y or 5Y OCIO Check-up (Fees Checked Every Year!)

Posted on by Chris in Briefings

Here’s why… Your needs change and the composition of most Investment Committees typically change over a 5-year period as well. The coverage and (more critically) the investment decision makers at your OCIO can change as well, all too regularly. (Fees should be reviewed and evaluated every year even without an RFP, simply because of a Fiduciary’s Duty of Care.)

If investment performance has been good (acceptable) and interactions with your coverage have been timely and beneficial, an RFI would seem entirely appropriate. You have a good relationship already and you simply want to validate that you are achieving the best results that your organization can achieve.

The RFI is composed of your own brief set of questions. The answers you obtain should inform you as to your next steps. You essentially validate whether the OCIO is helping you fulfill your mission or not. If you determine that the current OCIO arrangement is not optimal, then it may well be time to undertake a formal and comprehensive RFP process to replace the existing OCIO.

A Sample of 3 Key points to focus upon with a 5-year check-up:

  1. RETURNS – Your returns versus peers and versus the market benchmark(s). If there is underperformance, try to establish the root causes: asset allocation, re-balancing discipline, portfolio concentrations, overreliance on specific factors, etc. It is important to understand the “why” of what is not working properly for you.
  2. RISK PROFILE – Many providers continue to provide a crude (simplistic?) analysis of the portfolio’s risk profile. You deserve detailed graphs and tables (they should be presented in an intuitive fashion) since the analytical programs and tools are so readily available in the industry.
  3. COMPARISON TO PEERS – Your OCIO should provide you with insight as what is changing and what seems beneficial amongst your peers in the market space. You may learn of innovative approaches as to all aspects of investing, analysis, reporting, training staff, etc. There are often steps that can be taken to achieve greater efficiency and transparency that are simply operational and not proprietary in nature. These shared insights can improve your own efforts and organization. The OCIO can share these types of insights.

Want to learn more? Please contact Chris Cutler, Tom Donahoe or Safia Mehta at 917 287 9551.

Exposure to Diligence Performed by Your Institutional Investment Consultants

Posted on by Chris in Briefings

Allianz GI Structured Alpha Fiasco: Could It Happen in Your Pension Plan?

You have surely read how large pension plans invested in Allianz’s Structure Alpha strategies, each losing 5% to 50% of their assets, in March 2020. How could such catastrophic losses happen when these pension plans were all supported by board directors, investment staff, and large investment consultants? Is that not the model used by most large pension plans, including your own?

We think every pension plan should review the entirety of their investment governance process. The strong similarities in your governance process to the loss-ridden pensions, alongside increasing degradation in the quality of work at some large investment consultants, suggests that your pension could lapse into similar mistakes quite easily.

What Happened with the Allianz Strategy and Why Does It Matter?

First, let us review what actually happened with the Allianz Structured Alpha losses. Prominent investment consulting firms recommended it, pension staffs endorsed it, and pension boards approved it. The program superficially looked quite appealing as it did produce higher returns for years. The important caveats that its investors missed are that it could produce a -100% return in a market crash, like the one in March 2020, and that the Funds charged clients exceptionally high fees for the services provided. Some pension boards placed 5% to 7% or more of their portfolios in this single high-risk strategy with a single manager, and then lost 75% to 97% of all their monies invested. Frankly the return-enhancement strategy—selling “lottery tickets” in the form of far out-of-the-money put and call options—is widely viewed as highly speculative among sell-side risk managers, who would actively resist their own bank and brokerage traders from ever pursuing such a strategy.

We are of the view that a strategy so highly speculative and that increased the adverse correlations so dramatically in extreme scenarios, does not belong as part of a pension plan portfolio. Certainly, not in the sizing that occurred across so many pension funds.

How did it get into the pension portfolios? Most board directors, through no fault of their own, never worked at an investment bank or on a trading floor, and thus board directors rely heavily on staff and investment consultants. Some of their staff should have the expertise to have recognized the strategy’s weakness in a market crash. Large investment consultants should certainly have understood that the strategy did not belong in most clients’ portfolios, yet they still recommended, approved, and endorsed these investments for their pension clients. The enormous losses of $6 Bn+ spread across a large number of institutional consultant-advised pension funds evidence that there are structural problems that are needlessly exposing pension funds to enormous risks.

Key Areas Where Pensions’ Existing Investment Protocols Become Unreliable

We find that pension plans face several key areas of vulnerability with their existing investment process:

Faulty Internal Processes – Internal due diligence processes often have rigorous and lengthy checklists that provide investors with a false sense of comfort. It would be easy to see the Allianz strategy score highly against a detailed yet naïve checklist, presenting as it did a very attractive multi-year performance track record and managed by a large, deep-pocketed asset manager. No checklist is a substitute for investment expertise. If staff, the investment committee, and the investment consultant think they understand the strategy, but do not, the checklist approach will amplify the collective sense of false confidence.

Excessive Reliance on Institutional Investment Consultants – Pension staff and board directors rely heavily on the large investment consultants to perform a thorough analysis of each manager and strategy. Pensions should also be paying attention to what is happening inside the large investment consultants. Many have become for-profit firms that are not necessarily focused on providing the best research, and some of their due diligence reports read more like cheerleading for managers than presenting a balanced assessment. We have seen senior due diligence staff report to accountants and deep cuts to manager research efforts following acquisition by for-profit firms. Some consulting firms also face myriad conflicts of interest that may not be adequately disclosed. These problems are exacerbated by the extremely low fees paid to pension consultants. We have even seen employee-owned investment consulting firms themselves outsourcing their due diligence work. With the Allianz situation, we have seen some involvement by three different large consultants, so this type of failure is prevalent.

Pension’s Internal Investment Staff Lacking in Numbers, Training, or Experience – Earning a CFA or CAIA credential should ensure that the employee is qualified to understand and evaluate a simple strategy like Structured Alpha. Yet, one remembers the axiom about doctors: the procedure they are about to perform is the topic they got wrong on the medical boards! The same holds true for CFAs and CAIAs. An additional risk is that frequent employee turnover, common in the investment industry, or lack of professional development for staff, can disrupt the diligence and controls.

Even with an outstanding internal team, asking them to cover too many investments can lead to material oversights and omissions. Pension investors should carefully assess whether their processes include sufficient internal analytical resources to pursue the breadth of strategies in their portfolio. Needed workloads should be carefully quantified and compared to the workload asked of staff, to ensure a good alignment.

Limited Bandwidth of the Board Directors – Investment committees often contain members with varying degrees of investment expertise, or with substantial outside commitments. Often less vocal committee members feel may hesitate to challenge the more forceful voices, but they miss the opportunity to voice important insights. Nonetheless, the fiduciary duty remains with the full investment committee and ultimately with the board. Board directors could face liability issues if they fail to detect major omissions in the pension plan’s investment process. With the apparently diminishing reliability of the larger investment consultants, we believe board directors will face an increasing number of crises in their portfolios, along with the potential risk of personal liability.

Recommended Solution – Undertake an Investment Governance Review

The catastrophic losses in the Allianz funds occurred for investors despite a perceived robust investment process. Pension fund fiduciaries are right to be concerned about other possible problematic holdings already in the portfolio that have escaped proper vetting. There is a solution already widely available to help ferret out these “ticking time bombs.” An Investment Governance Review [IGR] addresses the following critical areas:

Governance Review – A review of the entire processes by which your pension considers, reviews, monitors, and deploys capital, to ensure that your duties of care and loyalty are met. This review is a detailed, step-by-step examination of the governance structure and how the duties are discharged. This would help ensure that the Board fulfills its Duty of Care as fiduciaries. Such an assessment, an “Investment Governance Review,” should occur at least biennially, if not annually. including:

Complete Portfolio Review – The assessment would review all current holdings with an eye to identifying whether the investment holds material hidden risks, correlations, or weaknesses, and whether the investment is properly characterized in the pension’s holdings and risk reports.

Assess Your Diligence Processes – A thorough review of diligence and approval processes typically leads to improvements in diligence practices. While no investment process is perfect, identifying strengths and weaknesses can help pensions mitigate and manage risks so that the portfolio will perform in a manner consistent with expectations. Moreover, our review often leads to improved future performance of investment staff, who become more effective with improved investment processes, and better at prioritizing and communicating with board directors. Too often, in-house analyses are colored by employee compensation concerns, wanting to avoid challenging the party who recommended the investment, or unwillingness by employees to admit that they simply lack the ability internally to analyze certain types of structures or asset classes. Complacency can arise when an investment has been held for a multi-year period, its returns are within the expected range, or alternatively the Pension Fund holds other investments obtained from the same provider. In such circumstances, style drift and changing risk profiles can be easy to overlook. We identity misalignments and provide recommendations on how to reduce or eliminate those problematic vulnerabilities.

Robust Analysis of Problem Investments – The Board may well be concerned with a specific investment that they currently own and have a vague/strong feeling of discomfort. We can perform a specific one-off analysis to vet the strategy, structure, and risks of a specific investment. Too often, the board directors see the investment listings neatly lined up in a report and the completeness of the report is assumed since all investments are listed. We would point out that the quality of the data that populates a holdings report (or risk report) can vary dramatically by asset type and structure, liquidity, and other critical factors. Often there are short cuts, estimates or other expedients or manual adjustments made that are not captured or disclosed on the report. These artificial constraints or “plug factors” can be themselves concealing risks or vulnerabilities from the Board.

The Allianz Structured Alpha Funds evidenced a fundamental failure in basic due diligence. In fact, the strategy can be viewed as quite simple with few moving parts. Surely there was sufficient expertise within each Pension Fund to perform a sufficient analysis. The strategy was simply the sale of put options on equity and sale of volatility options and the Fund pocketed the option premiums which were described as income/returns. Several of the largest losses occurred where the plan sponsor did hire large investment consultants to track and report on risk but that proved in retrospect to have provided a false comfort. For less than $20K per investment, these plan sponsors could have easily hired an independent expert team to dissect the entire structure and produce a detailed 10 -12-page analysis usually within a month of each request.

Our Value Proposition for Pension Plan Sponsors

Our Investment Governance Reviews provide a detailed assessment of your entire investment process. We assess the quality of services provided by your investment consultant. We review your portfolio construction and compare it to your investment policy statement. We review your board investment committee activities and reporting packages to see if your process is sufficiently agile yet comprehensive.

We assess the quality and workloads of your staff, to ensure that your investment process is being managed with the care you would expect in an institutional setting and to propose ways to improve the investment process. Moreover, the IGR is much less expensive than hiring a second consultant to monitor your portfolio. You benefit from our experience covering the investment consultants and OCIOs, and this benefit accrues to you in lower fees.

We are experts at assessing institutional consultants and financial governance processes, and we have helped clients address exactly the concerns we describe in this letter. We have also reviewed over 40 institutional investment consultants and can help you identify the strengths and weaknesses in your coverage from them. We possess strong capital markets backgrounds as well, and we have evaluated over 2,000 managers since 2003, covering virtually every asset class and investment style. Moreover, we have deep networks of experts developed over the last 30 years to ensure full product and strategy expertise. Our analysis is performed only by senior analysts. This team approach ensures than 90+ years of combined investment expertise is focused on your portfolio and your diligence.

We are an independent firm, a boutique that has NO conflicts and works SOLELY in the interests of the pension fund. We do not recommend investments and are paid only under retainer agreements with our clients, with strong NDA protections for those clients.

Importantly, we are not seeking to compete with your investment consultant. We have likely already evaluated them as potential candidates in our OCIO and institutional investment consultant search business, and we have a good understanding of their strengths and weaknesses. You can benefit from our expertise in those markets, because we offer a broader perspective on this market than you could possibly build internally from an occasional consultant search effort.

We look forward to speaking with you and answering any additional questions that you may have.

Want to learn more? Please contact Chris Cutler, Tom Donahoe, or Safia Mehta at 917-287-9551.