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by Anthony Reale, CIMA, and Mark Huamani As the search for alpha continues to be a challenge in these volatile markets, a trend is emerging in the investment management world. Investment outsourcing, which is the utilization of external parties for more discretionary investment management, has grown at a rapid rate in recent months. The latest surveys have indicated that at least 150 institutions have started outsourcing a portion of their asset management within the last year1. The recipients of these asset flows include investment managers and investment consultants who then implement a multi-manager structure to manage the assets. Investment outsourcing can take on several different forms. In some cases, institutional investors allocate an entire asset pool to an outside party for management, while in other cases, investors choose to outsource a more specialized investment style or mandate. Some investors will outsource the management of the alternative investments portion of their portfolio because of the specialized expertise and research that is required. One way to understand the definition and scope of investment outsourcing is to contrast this service to traditional investment management for institutional investors. While the traditional investment management function assumes some degree of fiduciary responsibility, greater levels of discretion are assumed by the asset manager who acts as an outsourcing agent. Other differences include compensation arrangements and a more extensive use of proprietary investment vehicles. Who is Outsourcing? Various asset owner segments and plan types are introducing investment management outsourcing as part of their investment approach. The U.S. Corporate and Taft Hartley defined benefit segment has historically been the main participant in this strategy. The interest in this model continues to gain traction in this larger investor group due to the cost advantages. This model also allows plan sponsors to tap into the investment and asset allocation expertise available at investment management firms. Limited resources available for the management and oversight of institutional investment asset pools have also driven the growth in the outsourcing model. Many plan sponsors have frozen their defined benefit plans, leading to a reduction of professional staff that performed many of the functions now offered by firms that provide third party outsourcing services. Recently, there has been increased interest shown by endowments and foundations in the outsourcing model. In the endowment and foundation space, limited resources can have an even greater effect given the preponderance of alternative assets utilized within those plans. Investment outsourcing partners can act as an extension of staff for endowments and foundations that may not be able to add resources internally. The significant alternative asset allocation in the non-profit segment has increased exponentially in recent years. Unfortunately, the level of knowledge and experience at both the investor and often the consultant level have not always kept pace with the increased usage of these investments. The recognition of this lack of expertise in the complex and volatile asset classes that comprise the alternative asset space has resulted in more institutional investors seeking the help of outside experts to augment the advice that their current consultants can provide. As a result, the outsourcing of alternative asset programs has gained in popularity. Smaller investors tend to be much more likely to outsource their portfolios. The oversight of smaller plans may still be limited to human resources or finance divisions that have other responsibilities in their organizations. It is also difficult for some smaller plans to compete or retain top talent. Poor investment results have prompted some smaller institutions to re-evaluate their existing managers, consultants and overall plan asset allocation strategy. Outsourcing can be seen as a way to improve results by hiring investment organizations with expertise in many different areas. One major benefit of an outsourcing model as compared to a traditional asset management model is the ability to effectively and quickly react to today’s rapidly changing financial markets. The outsourcing of asset allocation decisions to managers can result in a more tactical investment approach which can take advantage of market shifts more quickly. The typical asset owner will require investment board approval prior to changing their strategic allocation which can result in markets shifting before changes can be implemented. How Outsourcing can be Implemented There are several outsourcing models available to institutional investors today. The most widely used is the manager of managers approach. The manager of managers approach would enable an investment firm to allocate funds across a number of different managers within an asset class or strategy to achieve the optimal risk-return mix relative to the client mandate. Pooled vehicles, which typically carry lower fees than separate accounts, allow for an easier implementation of this approach for smaller investors. Another popular approach is to allocate a portion of assets to an investment manager that will employ a number of different strategies to achieve the maximum return for the given risk target. This approach allows the manager to use the wide array of mandates available to take advantage of broad expertise, and allows for a quick introduction of new strategies to the plan. Many larger investment consultants also offer some type of investment outsourcing capabilities thorough both separate accounts, and in some firms, proprietary commingled products. Investors who choose to use their current investment consultant for outsourcing can potentially benefit from the consultant’s knowledge of their plan. In recent years, firms have been established which are dedicated solely to investment outsourcing. Many specialize in the alternative assets space, offering products such as hedge fund of funds and private equity investment vehicles. Traditional asset management firms with broad and diverse investment capabilities have increased their presence in the outsourcing market. Some firms will include external managers, while others limit their offering to proprietary products. The latter approach may not be as advantageous for institutional investors who prefer less single-firm risk and more product diversification. Some attributes considered to be important differentiators in selecting an effective outsourcing partner include firms with a demonstrated expertise in the investment management side of the equation. These firms should have a sound business model for outsourcing, including experience with the administrative side of the business. An investment platform which can cover diverse global markets, preferably including alternative assets, is also important. Risk management across the asset class, investment instrument and manager level is also a critical component given the volatility of today’s markets. The ability to provide a more consultative approach that allows the investor to access the outsourcing agent’s intellectual capital and investment expertise should be considered an integral part of the relationship. Finally, flexibility to provide the investor with customized solutions is also important. Future of Investment Outsourcing Recent indications are that investment outsourcing will continue to grow as asset owners look to shed internal costs and leverage external expertise for asset allocation and investment selection decisions. However, there will continue to be concerns about the level of concentration risk due to a large asset size allocated to one investment firm. In addition, there is some sentiment that outsourcing may be yielding too much control of the core investment function by asset owners. The degree of investment discretion involved in investment outsourcing depends largely on the needs and preferences of the investor. Some investors who choose an outsourcing solution are seeking an approach that will, in essence, delegate most of the investment decision making processes, such as manager selection, to the outsourcing agent, while they retain approval of asset allocation targets. Other investors who outsource prefer to remain intimately involved in most areas of the investment process, limiting the scope of services provided by the outside party. To view the next article, Portfolio Management with Incremental VaR, click here. |
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