When a client opens an account with a wealth management firm, there’s a reasonable expectation the firm does the actual investing for the clients. But this isn’t always the case. Unbeknownst to many, a large percentage of money managers offload these duties to outside, third-party firms.
The practice is known as investment management outsourcing and it’s become widespread among both individual and institutional advisors. Here’s a closer look at outsourcing in today’s asset management space.
Who Outsources their Investment Duties?
On the institutional side, 81% of investment outsourcing is done by defined benefit plans (public and private pension funds) and non-profits (foundations and university endowments).1 But sovereign wealth funds, hospitals and insurance companies also participate.
When institutions fully transfer the investment decision-making responsibilities, they are running what’s referred to as an outsourced-Chief Investment Officer or ‘OCIO’ model.
These buy-side funds have unloaded assets at breakneck pace. Outsourced capital has exploded from just $91 billion in 2007 to $1.43 trillion in March of 2017.2 That total is estimated to exceed $2 trillion by 2020.3
The trend has been fueled by the tremendous growth of global assets over that time frame. This has strained money manager’s ability to oversee all of the assets (especially true for funds that are less than $1 billion in size).
For retail customers, wealth management and financial planning teams also outsource assets. Specifically, independent RIAs, Registered Investment Advisors, find similar challenges as assets under management swell alongside with compliance and regulatory costs.
In response, about one-quarter of financial advisors outsource client funds.4 It’s even more prevalent among more sophisticated financial planners. An astounding 54% of CFP professionals outsource some investment management duties for clients, according to Cerulli & Associates.4
Retail brokers utilize Turnkey Asset Management Programs or TAMPs to handle the implementation and portfolio management. These TAMP firms allow financial planners to focus on growing their business instead of vetting investment products, strategies and managers. This results in more time spent providing other wealth management advice on estate planning, health care concerns, tax strategies, asset protection and insurance.
Why Outsource Client Funds?
There is a compelling argument made as to why asset managers, and their clients, decide to outsource the investing. The most common include:
- Lagging Returns
- Lack of Resources
- Cost Savings
- Improved Risk Management
- Fiduciary Oversight and Regulations
Lagging returns, in absolute or relative terms, is arguably the most important reason to outsource. Chronic underperformance has left many plans in a seriously underfunded position. Outsourcing is one way to address the problem.
Jeff Scott of Wurts & Associates told ai-CIO Magazine that roughly 90% of institutional manager [under] performance can be attributed to improper asset allocation.5 Instead, he adds, many buy-side funds are ineffectively focusing solely on manager selection to solve the problem.
Lack of Resources
Smaller funds simply do not have the staff to handle the administrative, research, portfolio management, trading, due diligence, technological, risk management and back office requirements as assets have grown. It’s much more cost efficient to outsource assets than to hire and train new staff.
Equally important, many simply do not have the necessary investment expertise. OCIOs and TAMPs are heftily staffed with financial analysts, portfolio managers and CFAs.
On the retail side, outsourcing can actually save money, especially on portfolios of at least $1 million in assets. Consider that the underlying investment products typically add 75-100 basis points to annual account costs.
With passive investing strategies and scale, an outsourced TAMP model can save high net worth investors 30-50 basis points in cost per year.6 This equates to roughly $40,000 in annual savings on a $1 million portfolio. Thinking in terms of years and decades, it can be a powerful contributor to performance.
Also, many funds seek out sophisticated, risk-adjusted strategies offered by some alternative investment managers, like hedge funds. Many of these strategies (event driven, short-biased, merger arbitrage, market neutral, CTA commodities trading, etc.) would be very difficult to construct in-house.
While the most conservative version of the Fiduciary Rule did not pass, there is still serious pressure on managers to act in the best interest of their clients. In fact, many outsourced managers are willing to be fiduciaries themselves. Outsourcing also reduces potential conflicts of interest.
Who are these Outsourcing Firms?
There are further distinctions in the level of outsourcing firms offer. Some provide so-called implemented consulting, some conduct OCIO duties along with other services (OCIO+) and some are OCIO only.
Implemented consulting is provided by a number of firms including Rocaton Investment Advisors, Aon Hewitt, Gallagher Fiduciary Advisors, and Willis Towers Watson. OCIO+ is offered by Fidelity Investments, PNC Institutional Advisory, Mercer, and UBS. The more niche, OCIO-only services, are provided by names such as Clearbrook, Mangham Associates, Spider Management and Agility.7
Not surprisingly, Goldman Sachs, JP Morgan and Wells Fargo also offer investment consulting and advisory solutions but additionally provide the actual investment vehicles (mutual funds, ETFs, active strategies with their trading desks as counterparties, etc.) that are used by their institutional clients.
Outsourcing on the individual side occurs largely by TAMP firms. They select the individual securities for the portfolio inclusion, based upon both fundamental screens and technical analysis.
For an equity allocation, the securities include common or preferred stocks, exchange traded funds, mutual funds, or options. For fixed income allocations, it includes investment grade, high-yield and municipal bonds (common among high net wort individuals because of their local tax-exempt status).
You’re probably wondering, who are these TAMP companies? After all, they’re largely the one’s responsible for client performance. The larger companies include AssetMark, Orion, Envestnet, Brinker Capital, Lockwood and SEI. While not household names, they are responsible for allowing RIAs around the country to grow their businesses to such lofty levels.
Working in Investment Consulting
Outsourcing duties falls under the investment consulting umbrella. If you’re looking to get into this space, your focus of study should be heavy in finance and, if possible, geared towards investment management. Such programs include a Masters in Investment Management or Masters of Finance degree.
The CFA program is another consideration. The program’s comprehensive Body of Knowledge will teach students everything they’ll need to work in investment consulting.
Even if students pursue a Master’s of Finance degree instead, they’ll have learned the basic tools of investment management, which could help graduates land a position in investment consulting.
Some Concerns with Outsourcing
But outsourcing raises some hard question for some customers, both institutional and individual. What if the outsourced firm has poor performance? Why pay a fee to a financial planner to simply farm out the investing? What percentage of the funds is outsourced? Aren’t there now extra layers of fees that will erode long-term performance?
These are all valid concerns. Information on outsourcing does have to be disclosed to clients. In fact, sometimes high net worth individuals will actually sign a contract directly with a’ sub-advisor’. In this situation, the assets under management are still ‘controlled’ by the financial planner (for both compensation and fiduciary purposes).
Other RIAs are able to handle their client’s investments in house and question the benefits of the TAMP model.8 They argue that not every client will realize cost savings with an outsourced strategy. For accounts under $1 million, using a TAMP may actually increase fees. These extra fees can drastically eat into long-term performance.
Simply put, when portfolio values are going up (as we’ve seen in recent decades) few customers really question the model and it’s fee structure. It’s when markets turn south that investors typically take a closer look. A sustained bear market in financial markets could be the first major test for the outsourcing model as we know it.