The New GIPS-for-OCIOs Creates Strong Conflicts of Interest Affecting Asset Allocation

The Law of Unintended Consequences and Goodhart's Law will negatively impact the recently released Guidance Statement for OCIO Portfolios ("Statement") by the CFA Institute. Like Charlie Munger said, "Show me the incentive, and I will show you the outcome."

The Statement will impact OCIOs' asset allocation methodology. They will forever now ask, "Where will a client's asset allocation fall within the Required OCIO Composite?"

The Statement's mal incentives create legitimate reasons NOT TO BE GIPS COMPLIANT because it creates a direct conflict between the OCIO and their clients' needs.

But not being GIPS compliant likely creates a stigma and impacts an OCIO's ability to attract new business. After all, at least one search consultant has publicly declared they will not include OCIOs that do not fall in line. I thought it curious at the time drawing such a line in the sand when the Statement was still but a draft.

But given the incentives, if an OCIO chooses to be GIPS compliant, how they manage client accounts will likely be guided more by the Statement than by the true needs of their client. This is a perhaps the worst possible conflict.

The graph intuitively shows how, given the arbitrary constructs of the Required OCIO Composites in the Statement, accounts will tend to be allocated. To look the best over time, portfolios will group near the high-end of growth assets within each composite.

In a sense, in terms of the growth allocation to client portfolios, the Statement creates 5 model portfolios for the entire OCIO industry.

Consider this hypothetical. Imagine a client's needs are determined to be 30% in growth assets. The OCIO now has an ethical dilemma that is unbeknownst to the client.

A target allocation of 30% to growth assets would put the account near the lower bound of the Total Return Moderate Conservative composite (see directly above.) Over time, even if the OCIO is adding value, compared to their "peers" with higher growth allocations, they will likely fare poorly in the Required OCIO Composite.

One solution is for the OCIO to game the Statement rules. Specifically, they would create an Investment Policy Statement that would place the client portfolio in the Total Return Conservative composite by creating ranges or targets that qualify as such but still manage the portfolio with a 30% allocation to growth assets.

Worse, the OCIO may recommend the allocation to 25% or lower to growth assets to avoid gaming the Statement. But this would be a sub-optimal solution if the true allocation should be 30%. But the OCIO, however, will likely look superior in the most conservative composite... at the client's expense of having a sub-optimal portfolio.

Can Clients Still Trust Their OCIO?

This new Statement creates conflicts, mal incentives and Goodhart's gaming. For OCIOs, the incentive is either to cheat or mis-allocate assets. Doing neither means likely losing assets due to poor peer rankings. And for clients, can they now trust the advice of an OCIO that chooses to be GIPS compliant?

As David Salem said in our podcast, speaking to asset owners searching for an OCIO, "I would encourage them to exclude any OCIO firms that claim compliance with these GIPS standards."