By Jeffrey M. Covell, Area Senior Vice President & Area Assistant Director

INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES: Investment Basics: Evaluating the OCIO through Performance Attribution and Analysis By Jeffrey M. Covell, Area Senior Vice President & Area Assistant Director The outsourced chief investment officer ( OCIO ) model has gained a lot of attention from plan sponsors over the last few years. According to Pension & Investments, over $1.2 trillion in institutional assets 1 currently use this model, with defined benefit funds making up an estimated $400 to $800 billion of this total. The OCIO model allows for the delegation of some key fiduciary responsibilities to an investment manager: setting the overall asset allocation for the plan, risk management, selecting, terminating, and replacing investment managers and funds, rebalancing the portfolio, managing asset transitions between managers, and sourcing cash within the investment portfolio on an on-going, as needed basis to pay benefits and other administrative expenses. Plan sponsors have migrated to the OCIO model for various reasons. The OCIO model helps alleviate some of the key challenges in traditional investment consulting. For example, capital markets are very dynamic and are becoming increasingly complex. This can create issues both in terms of speed/efficiency as well as (lack of) investment expertise. In a traditional advisory consulting model, the investment consultant may have to wait until a regularly scheduled meeting (i.e., quarterly or semi-annually) to educate the trustees and recommend an opportunity. By this time, the opportunity may have passed. In an OCIO model, the OCIO can make the decision to invest at the appropriate time without the necessary approval from the board. Additionally, board members are frequently not investment professionals and the OCIO model can help to protect board of trustees from liability. 1 Williamson, Christine. "Outsourced Assets Top $1.2 Trillion after a 26% Increase in a Year." Pensions & Investments. 7 July 2014. Web. AJG.COM

Although a plan sponsor delegates key investment-related responsibilities to an OCIO, the plan sponsor is still obligated to monitor the OCIO. Therefore, it is critical that the plan sponsor creates a framework to effectively measure and evaluate the performance of the OCIO. One way in which they can measure and evaluate the effectiveness of the OCIO is through total fund performance attribution and analysis. Performance attribution is the process by which a plan sponsor evaluates the cause(s) or source(s) of return. Performance attribution comes in many different flavors, many of which are used in both traditional consulting as well as the OCIO model. For the purposes of this paper, we focus on relative attribution and we attempt to answer the following question, Why has the total fund outperformed or underperformed its policy index? The key to successful performance attribution is developing a policy index that represents an appropriate blend of the composite level benchmarks based on what percentage of the fund is invested in each asset class. The following table illustrates a typical policy index. Asset Class Benchmark Target Weight US Equity Russell 3000 Index 45% International Equity MSCI ACWI ex US Index 15% Fixed Income Barclays US Aggregate Bond 30% Index Hedge Fund of Funds HFRI Diversified Fund of 10% Funds Index Total Fund 100% In the policy index above, each asset class has a target weight within the policy index based on the strategic asset allocation analysis and recommendations. The target weights should not change frequently only when a new asset allocation policy is adopted. The policy index is meant to provide a passive 2 measure of the strategic asset allocation of the total fund. Each asset class is assigned an appropriate benchmark, the components of which make up the policy index. In the table above, we use the Russell 3000 Index for US Equity. 2 For most asset classes, an investable passively managed index fund is available. However there are some asset classes where a passively managed index is not available (e.g. hedge fund of funds, private equity). 2 AJG.COM

These benchmarks should represent broad exposure to the particular asset classes. The policy index should serve as a barometer for the performance of the strategic asset allocation, acting as a diagnostic tool to measure the performance of the OCIO in an unbiased manner. The OCIO should be aware of the policy index and underlying asset class benchmarks, including the composition of the benchmarks and how they ve performed. Often, the benchmark is an integral part of the investment process and helps to drive decisions made by the OCIO. The establishment of an appropriate policy index is likely the single most important factor in effective performance monitoring of an OCIO. After an appropriate policy index is constructed, the plan sponsor can then begin to evaluate the performance of the OCIO. The table below illustrates the performance on a cumulative basis (annualized for periods greater than one year) of a hypothetical total fund compared to a policy index. 1 Quarter 1 Year 3 Years 5 Years Total Fund 6.00% 15.62% 11.00% 10.30% Policy Index 5.64% 17.74% 10.63% 11.58% As indicated in the table above, there are periods of over and under performance relative to the policy index. This over or under performance relative to a policy index is primarily attributed to two factors, asset allocation decisions and investment manager selection decisions. The asset allocation decisions are a function of how the OCIO positions the portfolio relative to the target weights in the policy index. The OCIO has the ability to over or under-weight a particular asset class relative to its target in the policy index (typically within an allowable range). For example, if the target weight to US Equity in the policy index is 45%, the OCIO may decide to overweight US Equity relative to this target and maintain a weighting greater than 45%, say 47.5%. If the OCIO decides to overweight a specific asset class that outperforms the policy index, this would be additive to the performance of the total fund relative to the policy index. Conversely, if the OCIO decides to under-weight an asset class that outperforms the policy index, this would subtract from the performance of the total fund relative to the policy index. 3 AJG.COM

The approach most commonly used today for component and total fund level asset allocation attribution is based on findings from a study done by Brinson and Fachler in 1985. Their equation to determine the impact of a weighting decision is as follows. (WA WB) * (RB RTF), where WA = Asset class weight in portfolio WB = Asset class target weight RB = Asset class benchmark return RTF = Total fund benchmark return As an example, a portfolio that has a domestic equity weighting of 47.5%, an asset class benchmark return of 10%, while the policy index calls for a 45% domestic equity weighting and the total fund policy index returns 8%, the equation will show that asset allocation decision had a positive effect on the portfolio of.05%. The table below outlines how the asset allocation decisions can have either a positive or negative impact on total portfolio performance relative to the policy index. Overweight Asset Class Under-weight Asset Class Underperform Subtractive Additive Outperform Additive Subtractive In addition to deciding to overweight or under-weight a particular asset class, the OCIO also has the ability to hire and fire active managers within the investment structure. The plan sponsor should effectively evaluate whether the use of active management (i.e., manager selection decisions) was additive or subtractive to the total fund performance relative to the policy index. This can be done through performance attribution. The plan sponsor needs to analyze whether the use of active management within the total fund added (or subtracted) value relative to passive management. This can be calculated by using the following formula: (WA) * (RA RB), where WA = Asset class actual weight in portfolio RA = Asset class actual return RB = Asset class benchmark return 4 AJG.COM

This measure quantifies the value added by investment manager selection decisions made by the OCIO within each asset class of the portfolio. It will be positive when the manager outperforms the benchmark, and negative when it underperforms. Measuring the impact of investment manager selection decisions is extremely important, especially when the portfolio is utilizing active investment managers. The plan sponsor can identify if there is value added relative to the fees they are paying for active management. The table below illustrates an example of how active management selection can be additive and subtractive to the total fund performance relative to the policy index. The table shows each asset class s weighting and return relative to its specific benchmark. The example below assumes that active management is utilized in each asset class. Asset Class Portfolio Weight Segment Return Benchmark Benchmark Return Manager Selection Impact US Equity 46% 10.00% Russell 3000 9.87% 0.06% International Equity 14% 5.40% MSCI ACWI ex US 7.54% -0.30% Fixed Income 28% -4.28% Barclays US Aggregate -1.20% -0.86% Hedge Fund of Funds 12% 1.20% HFRI Diversified Fund of Funds 2.70% -0.18% For illustrative purposes only. As the table above indicates, three of the four asset classes (International Equity, Fixed Income and Hedge Fund of Funds) detracted from relative performance due to the underperformance of the active managers relative to the asset class benchmark return. Utilizing Fixed Income as an example, the active managers collectively returned -4.28% for this period. During this same period, the Barclays US Aggregate returned -1.20%. Clearly, the active managers detracted from performance given the underperformance of the fixed income composite relative to the passively managed benchmark. Plan sponsors can utilize analysis similar to this to identify areas in the portfolio where active managers are adding and subtracting from relative performance. This allows the plan sponsor to evaluate the manager selection decisions made by the OCIO and whether they are adding value based on their manager selection process. 5 AJG.COM

The preceding discussion focuses on the mechanics of performance attribution at specific points in time (i.e., what was the value added from manager selection or asset allocation decisions over the last quarter or the last year). Plan sponsors may also want to analyze performance of the OCIO over cumulative periods, rolling periods or on risk-adjusted basis. Additional analysis that plan sponsors should consider: Comparing the performance of the total fund versus an asset allocation index and policy index over cumulative or rolling time periods. In addition to a policy index, the plan sponsor may want to compute an asset allocation index. The main difference between an asset allocation index and policy index is that the asset allocation index weights (i.e., the amount in each asset class) change on a regular basis (e.g., quarterly) based on the amount invested in each asset class. In contrast, the policy index weights do not change on a regular basis and are static. The difference in performance between the asset allocation index and the policy index indicates whether the asset allocation decisions were additive or subtractive. Value added through rebalancing or tactical over/under weighting of asset classes can be measured by comparing the asset allocation index and policy index. Analyzing the total fund s risk adjusted performance. Plan sponsors may also want to evaluate the performance of the OCIO based on various risk adjusted measures. In addition to evaluating the total fund performance, the plan sponsor should also take into account the amount of risk (volatility) the total fund experienced to earn such return. For example, comparing the Sharpe Ratio of the total fund versus the policy index will indicate whether the total fund is earning a superior risk adjusted return relative to the policy index. The Sharpe Ratio measures the return per unit of risk. The higher the Sharpe Ratio relative to the policy index, the better risk adjusted return the total fund is earning (all else being equal). The Sharpe Ratio is just one measure of risk adjusted returns that plan sponsors may want to consider. Utilizing other consistency measures to analyze performance. The plan sponsor may want to evaluate performance of the total fund to determine whether the OCIO exhibits any consistent performance patterns. 6 AJG.COM

For example, the plan sponsor may want to evaluate the batting average of the total fund. The batting average measures the percentage of time the total fund outperforms the policy index on a monthly or quarterly basis. This statistic is used to measure whether there is any consistency in the out or under performance. The plan sponsor can also evaluate the performance in positive or negative market environments to determine if the OCIO is (or is not) adding value in either or if there is a particular pattern to the historical track record of the OCIO. CONCLUSION Given the importance and complexity associated with monitoring OCIO performance, a plan sponsor may want to consider hiring a neutral, third party firm to help in the performance monitoring process. By developing a framework to effectively evaluate the performance of the OCIO, the plan sponsor will have the tools to determine whether the OCIO model is adding or subtracting value. 7 AJG.COM

About the Practice Jeffrey M. Covell, Area Senior Vice President & Area Assistant Director is part of the Institutional Investment & Fiduciary Services practice of Arthur J. Gallagher & Co. (Gallagher Fiduciary Advisors, LLC), focused on improving the investment program of your benefit plan and other investment pools. Gallagher s Institutional Investment & Fiduciary Services practice is a group of established, proven investment professionals who provide objective insights, analysis and oversight on asset allocation, investment managers, and investment risks, along with fiduciary responsibility for investment decisions as an independent fiduciary or outsourced CIO. Jeffrey M. Covell, CFA Area Senior Vice President & Area Assistant Director Institutional Investment & Fiduciary Services jeff_covell@ajg.com 202.312.6965 www.ajg.com JEFFREY M. COVELL, CFA Area Senior Vice President & Area Assistant Director 2015 Gallagher Fiduciary Advisors, LLC Investment advisory, named and independent fiduciary services are offered through Gallagher Fiduciary Advisors, LLC, an SEC Registered Investment Adviser. Gallagher Fiduciary Advisors, LLC is a singlemember, limited-liability company, with Gallagher Benefit Services, Inc. as its single member. Neither Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC nor their affiliates provide accounting, legal or tax advice. 8 AJG.COM