Introduction
Assessing OCIO performance is an important part of evaluating OCIOs as candidates for our clients. The task also has many imbedded complexities. The CFA Institute has taken steps to address some of these complexities.
We explain here why we think the CFA Institute is moving in the right direction, but we still believe that GIPS Standards do not provide a complete picture of #OCIO performance. Instead, when we evaluate OCIO performance we assess performance by asset class, looking both at performance relative to client specified asset class benchmarks, and also performance driven by asset class selection.
Background
The CFA Institute and its predecessor AIMR set the foundation for assessing investment performance of individual investment managers. They created the Performance Presentation Standards, which evolved into the Global Investment Performance Standards or “GIPS,” an acronym trademarked by the CFA Institute.
In a world where the foundation for almost all investments were liquid, publicly traded securities, GIPS’s uniform methodology revolutionized the asset management industry. GIPS created standardization in performance reporting and disclosures, which greatly increased transparency and comparability in our industry. The standards allowed allocators to access improved and objective information about the investment performance of their investment managers.[1]
[1] To improve reliability and lessen dependence on investment managers’ own self-reporting, an ecosystem of independent GIPS compliance developed. The audit industry started to provide GIPS attestations which are basically two main levels of independent, third-party attestations. Verification (firm-wide) and Performance Examination (composite-level), These attestations simply assert whether or not the investment manager calculated and presented their performance in compliance with GIPS standards. The auditor verification does not provide assurance on the accuracy, validity, or performance of any specific composite report. A firm cannot claim that a specific composite is “verified”. The GIPS standards merely tell the investor that the performance has been calculated and presented in compliance with GIPS standards.
The Initial Application of GIPS to OCIOs Created Confusion
It is understandable that the CFA Institute would wish to extend GIPS to cover OCIOs, since OCIOs are becoming increasingly important in the institutional asset management marketplace. However, OCIOs seeking to comply with GIPS faced a major challenge: GIPS did not sufficiently allow differentiation of client-types in the OCIO managers’ composite returns. The result was a mixing of low-risk, immunized pension plans with return-seeking foundations into composite returns. Only when an OCIO’s client mix was relatively uniform did the GIPS standards offer any hope of being a meaningful measure of an OCIO’s skill in advising clients.
Another major challenge with computing GIPS returns for OCIOs is the fact that OCIO strategies are not directly comparable across OCIOs. For example, some OCIOs pursue 100% liquid investment strategies into equities and bonds, while others will allocate up to 50% in private strategies. It would be difficult to assess the performance of the liquid OCIO strategy against the OCIO with the 50% private strategy.
Moreover, within equities are sub-asset classes with vastly different risk profiles. Within liquid equity strategies, OCIOs may present choices of value equities versus growth equities. More broadly, OCIOs may offer relatively low-risk consumer staple equity strategies, versus highly illiquid venture capital investments into AI and biotech. Comparing an OCIO that is offering a high proportion of venture strategies with a 10-year commitment, with an OCIO that offers a high proportion of value equity strategies would create complications, since the underlying question is the asset allocation choice and the relative success within those choices. The relative performance comparison only scratches the surface of the OCIO performance analysis.
Challenges from Including Illiquid Private Strategies in GIPS
OCIOs present challenges that stretch the limits of GIPS. At its inception, GIPS primarily addressed investment strategies consisting of liquid securities with transparent pricing. That is not the case for many OCIOs that may have 10% to 50% of the portfolio invested in semiliquid or illiquid strategies. The pricing transparency of those assets can range from high for many hedge funds, to very low for venture capital investments.
So how does GIPS handle this transparency challenge? It does so indirectly, by implicitly relying on valuations provided by the managers of the underlying private strategies. This method is called the “practical expedient” valuation method. With current market conditions, the “practical expedient” tends to have the following attributes:
- Understated volatility: Valuation changes are driven by major, infrequent events, like pricing for latest capital raises, or private corporate sales. Thus, the volatility of valuations from the “practical expedient” method are greatly dampened compared to publicly-traded investments.
- Overstated valuations: We believe that managers of private strategies have a tendency to be optimistic in the face of distressed market conditions. That appears to be the case for private credit managers, where the private credit funds have de minimis losses over the last year, whereas their publicly-traded analogs are often trading around 25% lower. Older private equity funds also face a similar dynamic in private markets, where investors will trade their 5- to 10-year-old vintages at times with discounts of 25% to 50% off of the values stated by the managers.
- Overstated private returns: If the valuations are overstated, so are the returns.
CFA Institute Seeks to Implement Better OCIO GIPS Standards
The most recent proposed GIPS standards present a material improvement over the initial GIPS standards, because they allow for the breaking out of “growth assets” from “capital preservation” or “liability management” assets:
Required OCIO Composites for Total OCIO Portfolios
| Required OCIO Composites | Allocation to Liability-Hedging Assets | Allocation to Growth Assets |
| Liability-Focused Aggressive Liability-Focused Moderately Aggressive Liability-Focused Moderate Liability-Focused Moderately Conservative Liability-Focused Conservative | 0–20% 21–30% 31–50% 51–75% 76–100% | 80–100% 70–79% 50–69% 25–49% 0–24% |
| Required OCIO Composites | Allocation to Risk-Mitigating Assets | Allocation to Growth Assets |
| Total Return Objective Aggressive Total Return Objective Moderately Aggressive Total Return Objective Moderate Total Return Objective Moderately Conservative Total Return Objective Conservative | 0–20% 21–30% 31–50% 51–75% 76–100% | 80–100% 70–79% 50–69% 25–49% 0–24% |
Source: CFA Institute “Exposure Draft of the Guidance Statement for OCIO Strategies” from October 16, 2023
Challenges from Including Heterogeneous Strategies in GIPS Composites
As can be seen from the #CFA Institute’s proposal, #OCIOs will be permitted greater gradation of risk appetite by client type, which is a helpful improvement over the GIPS standards for traditional liquid managers. However, the new standards do not distinguish for:
- Volatility dampening and income smoothing of “growth asset” strategies that are private assets, nor the valuation risks assumed by using the “practical expedient” valuation method.
- Gradations of risk, primarily in the Growth Asset category, which inappropriately places venture capital and value investing in the same risk bucket.
- Differences in liquidity across #OCIO clients.
We note that the Alpha-NASDAQ OCIO benchmark generally accepts these flaws, but provides gradations of 10 risk-appetite buckets of 10% allocation differences between Growth Assets and Capital Preservation assets. Like the CFA Institute OCIO GIPS standard, the #Alpha-NASDAQ OCIO benchmark approach does not correct for illiquidity difference, use of the “practical expedient” accounting practice, volatility dampening or income smoothing.
Conclusions
#GIPS standards for OCIOs are evolving. We believe the CFA Institute is taking a step forward by recognizing that not all OCIO clients are identical, and allowing OCIOs greater ability to distinguish among them by broad bucketing.
Unfortunately for us as #OCIO search consultants, we cannot rely on these standards, nor the AlphaNASDAQ approach, because neither account for the use of “practical expedient” accounting, volatility dampening and income smoothing, or differences in liquidity.
We encourage the CFA Institute to continue to consider evaluation of GIPS practices for OCIOs, while realizing that they may want to consider additional disclosures covering liquidity, asset class performance, and percentage use of “practical expedient” accounting methods in portfolios.
In the meantime, our approach is to gather asset-class level performance, and information on liquidity restrictions and valuation practices, to help us assess performance at a deeper level.
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