As we have discussed, good governance exists when the board and investment committee are allowed to focus on issues that impact the long-term objectives of the fund, rather than being responsible for investment decisions. Part of good governance is simply acknowledging the fact that managing investable assets is a full-time job, and not some collateral duty for the investment committee, the board, or the CFO.

While the investment committee or board focuses on strategy and the external investment managers select securities and investments, there exists a need to connect (or link) the right investment managers and strategies to the big-picture items recommended by the board. Constructing a connection between the investment committee (or board) and the external investment managers is done through one of the governing models we discussed earlier (Traditional, Contracted, or Internal Model). Metaphorically speaking, this individual (CIO) or group (investment office or consultant) can be thought of as the director between the script and the performer, or the conductor between the music and the musician.

Throughout the course of this book, we have discussed several approaches to answering “how” a governing body might supply that middle connection, and we hope we made it clear that our bias is toward an internal investment office or contract office rather than a “do it yourself” or consultant solution. A recent phenomenon that we have yet to discuss is a trend toward investment outsourcing.

Many smaller institutions discovered the Traditional Model (i.e., using a consultant) was an effective method for improving their investment management program from the “do It Yourself” approach. However, as the institutions’ funds grew in size, most came to the realization that the traditional model and the consultant did not keep pace with their needs of good governance. In search of ways to address these needs, many institutions have looked for a different strategy, and outsourcing has been the fastest growing solution.

According to a Northern Trust survey, in 2012, 14% of institutions outsourced all of their investment management activities. In 2013, that number doubled to 29%. We believe this is a step in the right direction. Unfortunately, with such strong growth in the space, many marketers have grabbed hold of the word “outsourcing” and obfuscated its meaning to the point where it has left many institutional investors wondering what outsourcing models truly exist. To bring clarity to the issue we will discuss the three most common outsourcing solutions: (1) oCIO (also called discretionary consulting), (2) Pooled or commingled accounts, and (3) the contracted investment office. There will be some institutions that offer a variation of an outsourcing model, and others that call it something entirely different, but at its core these are the three main outsourcing solutions.

In a study entitled “The New Gatekeepers: Winning Business Models for Investments Outsourcing,” Casey Quirk defined outsourcing as an investor delegating “…some level of investment discretion to a third party for a portfolio-based fee.” Casey Quirk and others note that the outsourcing assignment may be all or part of the institution’s assets, that discretion may be all-inclusive or partial, and that fees may be asset-based, fixed, or performance-based. So what does this mean for you? It means the outsourcing universe is enormous, and the number of varying arrangements is immense. It has also caused confusion among institutions looking at outsourcing options because they aren’t exactly sure at what options exist. Under this common definition, almost any relationship can be called outsourcing (and is). However, as we mentioned, there are really only three basic outsourcing solutions.

The first of the solutions is the Outsourced CIO (oCIO) product, also known as discretionary consulting. This product was developed by investment consulting firms as a way to repackage their services into a higher margin business. The oCIO model is essentially a continuation of the traditional approach, the primary difference being that an oCIO, with full discretion, implements the manager recommendations and any asset allocation changes. This contrasts with the more traditional approach in which the consultant offers recommendations and the implementation is executed through the institution (the board, investment committee, or CFO). Outside of implementation, the only other difference is cost. The oCIO model has a much higher price tag than the traditional investment-consulting model; yet the advice (such as which managers to hire and fire or asset allocation policy) must, in fact, be the same. If the advice being offered differs between the firm’s investment consulting arm and the oCIO arm, one has to ask which entity gives the better advice. As fiduciaries, investment consultants have a duty to recommend the managers that they believe are best suited for the portfolio. Because the objectives of the portfolio haven’t changed, how can the recommendations of the firm’s oCIO arm be any different than those from their investment consultant arm?

You have to give consultants credit for figuring out a way to get institutions to pay more for the same product they have always delivered. By paying a higher fee, the oCIO division of the consulting firm will execute their own advice. An institution that elects to use an oCIO is paying for the execution of advice—the same advice offered by the consultant. Not much credit is due to the institution for paying the higher fees, as they could implement all of the consultant’s advice without the added cost. Prior to the oCIO outsourcing product, investment consultants were giving their clients the best and soundest advice to each client, or so they said (and one should believe.)

The second outsourcing solution is a pooled or commingled fund. These funds are sometimes referred to as “endowment style” funds. They can also be thought of as “give us your money and go to sleep, we’ll handle everything” funds. The best things they “handle” are fees—their own fees. If only the returns were as big as the fees. Institutions that use the DIY Model of governance and do not want to participate in the management of their funds often believe that the resumes of the people associated with the pool, and their touted “endowment style” fund, will be enough to properly fulfill their duties.

While the idea of a pooled, or commingled, endowment-style fund will resonate with smaller institutional investors, the “everybody in the pool” approach doesn’t align well with many institutions’ investment objectives. For smaller institutions ($10 Million or less) worried predominately about diversification and access to investment managers, this solution may well be a viable option. Yet, these smaller institutions must weigh the tradeoff between customization (or lack thereof) and diversification. Pooled and commingled funds are designed to be a “one-size fits all” product that can benefit from scale. These funds often times over-diversify across managers (some firms have over 200 managers) and asset classes in order to accommodate that scale. The high degree of diversification and high fees often cause a diluted performance.

The last of the outsourcing CIO models is the shared or contracted office. This is the Peter Drucker outsourcing that many people think of when thinking of “outsourcing.” Clients (members) are limited, portfolios are customized, and discretion is determined entirely by the client. Essentially, the contracted investment office acts as an institution’s in-house investment office and operates in a similar capacity. This includes assisting not only in meeting the return objectives, but also developing funding requirements, addressing cash-flow needs and volatility concerns, providing support during audits, and aiding corporate finance decisions. Working with various levels of discretion, the contracted investment office is tasked with developing an investment policy statement, implementing the investment program, performing managerial due diligence, making asset allocation recommendations, establishing risk metrics, creating performance reports, conducting research on various asset classes, reviewing all limited partnership agreements, advising on custodial and brokerage accounts, monitoring liquidity, and tilting the portfolio given various market conditions. One of the benefits of a contracted investment office is their lower cost. Institutions that can’t afford or choose not to afford an internal investment office are able to replicate an in-house office at a fraction of the cost. A contracted investment office also provides their clients with the responsibility, accountability, and an advocacy that is typically only found internally.

There are some approaches to outsourcing that are hybrids (really a variation across multiple solutions) who take fewer clients and have mostly separate accounts, but who also offer pooled funds—most often funds in the alternatives space. Some hybrids are actually close to the shared (or contract) office; they just offer a pooled product. Yet, these hybrids often times have more accounts, which reduces service levels, and are generally more focused on new business, which takes time away from management of the investment portfolio and due diligence. Nevertheless, these hybrids have a place for some institutions.

The many variations in these outsourcing models cause confusion among institutional investors, as it’s not only difficult to distinguish one outsourced provider from the other but, perhaps more importantly, which outsourcer actually has your institution’s best interest in mind. In our opinion, the best way to navigate this problem is to determine if the outsourcer is acting as a principal or as an agent. Much like the real estate and brokerage communities, an agent acts for the client’s interest while a principal acts for his own. The same concept applies to outsourced CIO models; those acting for themselves first are principals and those acting in the client’s interest are agents. How to distinguish from one another is not as hard as one might think. Size is the first indicator. A large organization that operates with multiple layers of management must focus their efforts on the organization and not on your fund. The number of clients can also be an indicator. Although a firm with many clients might look attractive initially, with a little thought, one would quickly realize that larger firms require more time to be exerted on other funds, which limits the amount of attention paid to your fund. The existence of pools or a large sales force are other indicators that the firm is acting as a principal and not as an agent.

Which outsourcer you chose depends on your goals and your institution’s circumstances. There is no inherently right or wrong answer. Using an organization as a principal may make sense for your institution. It is, however, important to recognize there are viable outsourcing alternatives. Outsourcing serves a purpose for many institutions that have needs to be met.

Outsourcing is a way for institutions to manage their investment risk and align the investment strategy with the institution’s financial goals. Institutions want to leverage the professional expertise of these service providers. It might be easy to stick with the status quo, but it’s imprudent not to explore your options.

The following chart outlines the choices for the institutional investment committee that choose not to DIY via the board or an internal office. The gold path is the path I think will provide the best results for most organizations. Each successive stop on the path is better than the one before it until you reach our bias the contract office.