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Politics of Public Fund Investing Part I Colorado County Treasurer’s Association June 26, 2012
Benjamin Finkelstein, CFA
Should a public fund manage money like Wall Street?
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Preservation vs. Performance
Portfolio Manager: “I have great news for the Board of County
Commissioners! Our unit of local government is in the top 1% quartile of all professional money managers who use the Merrill Lynch 1-3 yr Government index.
“We realized only a 3.00% portfolio loss while the Merrill Lynch benchmark lost 3.50%.”
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When managing a public fund portfolio what is the most significant risk you face?
Job Risk
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Job Risk
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When managing a public fund portfolio what is the most important skill you can possess?
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Communication Skill
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The Game Plan
Begin to show how a public fund with limited time, resources, and staff, can professionally manage the investment portfolio
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“Politics” is used to describe a structure for thinking how Main Street should manage, measure and report investment portfolio performance
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Two Types Of Portfolio Risk
POLITICAL Principal Preservation • Objectives
– Safety – Liquidity
ECONOMIC Enhance Earnings • Objectives
– Optimize Income
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Dilemma How To Balance Competing Objectives Preserving Principal while Optimizing Income
What Differentiates Main Street from Wall Street?
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I. Philosophy
II. Mission
III. Risk Objectives
IV. Management Style
V. Performance Measurement
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Risk Management
Return Management
I. Philosophy
Manage risk not return
Main Street Political
Wall Street Economic
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Principal Focus Preservation
Return of Investment Principal Focus Performance
Return on Investment
II. Mission Preserve and Protect
Main Street Political
Wall Street Economic
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Be the market Political Uncertainty $Pain not = $Gain
GASB 31 vs. Budget Budget Stability
Beat the market Economic Uncertainty
$Pain = $Gain Risk vs. Reward Market Volatility
III. Risk Objectives To Be or to Beat
Main Street Political
Wall Street Economic
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Passive
Investing – Intends to Hold
Fund Bodyguard
Market Risk Premiums
Active
Trading - Sell before Mty
Fund Mercenary
Price Movement
IV. Management Style How are returns being enhanced?
Main Street Political
Wall Street Economic
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Market Rate of Return
Fiduciary Benchmark
No Peer Group
Suitability
No Historical Returns
Total Return
Market Benchmark
Peer Group Comparisons
Relative Returns
Historical Returns
V. Performance Measurement Accountability
Main Street Political
Wall Street Economic
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Summary
What differentiates Main Street from Wall Street
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Public Funds Are Not Pension Funds
Philosophy Manage risk not return
Mission Preservation dominates performance
Objective To be not beat the market / Income not Growth Management Style
Investors not Traders / Passive not Active Performance Reporting
Measuring Suitability / Not Market Indices
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Building A Politically Correct Portfolio Part II
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The Policy - Rank The Risk
SAFETY %
LIQUIDITY %
INCOME % Total: 100 %
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What is the most frequent question asked about the portfolio? Is investment practice following investment policy if only one policy objective is the focus and that objective is the least important of the three?
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What Is Politically Correct?
I. Portfolio maintains a prudent balance between preserving principal while achieving a market rate of return.
II. Suitability of portfolio can be both quantified and monitored for compliance.
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Construction Steps I. Develop investment plan
Policy – Plan – Portfolio II. Define management style
Trader – Investor – Buy and Hold III. Determine risk tolerance targets
Liquidity – Interest Rate Risk – MRR IV. Designate portfolios
Liquidity – Income
Developing An Investment Plan
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Policy Words General Static
Plan Portfolio Specific Dynamic
w Policy’s describe legal not suitable w Policy’s cannot be marked to market w Policy’s provide no cash flows w Policy’s do not pay obligations
Policy Is Not A Plan
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Policy Objectives Safety Liquidity Income
Plan Priorities Liquidity Income Safety
Liquidity Risk or the premature sale of a security to meet an unexpected obligation creates the greatest political / principal risk to a portfolio and career
Rulebook versus Playbook
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What is an Investment Plan?
The investment plan is a portfolio interpretation of the investment policy. It quantifies what is a suitable portfolio.
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Policy Plan
Portfolio
Legal to Suitable
Policy – Plan – Portfolio
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Investment Plan
1. Fiduciary Benchmark
2. Establishes an investment decision making discipline throughout budget and market cycles
3. Creates a compliance framework for monitoring and reporting the portfolio’s suitability
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Defining Management Style Trader – Investor – Buy and Hold
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Trader versus Investor
• Trader seeks to enhance portfolio returns by buying low and selling high. Strategy is founded on selling security before maturity.
• Investor seeks to enhance portfolio returns using the markets liquidity, structure, and/or credit premiums.
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Active Trader
• Active is a total return style of portfolio management which recognizes and realizes gains and losses.
• Active management styles rely on price change and market benchmark comparisons
• Active management styles typically make budget concessions to offset market volatility and uncertainty
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Passive Investor
• Passive management does not simply buy and hold investments until maturity.
• Passive management actively rebalances the portfolio current holdings with the investment plan to achieve a market rate of return throughout budget and market cycles.
• What distinguishes passive from active is a rebalance strategy which consist of a simultaneous buy and sell.
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Buy And Hold Investor
• Buy and Hold investor does not rebalance • Buy and Hold investors have a “set it and
forget it” portfolio strategy
• Buy and Hold investors ignore their portfolio strengths and weaknesses relative to current market conditions
• Buy and Hold investors add no value to
portfolio management process
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Determine Risk Tolerance Targets
Ability and Willingness Liquidity – Interest Rate Risk – MRR
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Risk Tolerance - Objective
• Determine funds ability to take risk – Historical liquidity due diligence – Interest rate risk due diligence – Capital market risk premiums
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Risk Tolerance - Subjective
• What’s funds willingness to take risk? – Expertise of portfolio manager – Investment committee sophistication – Defining Portfolio Purpose
• GASB 31 vs. Budget • Sleep well vs. Eat well
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Liquidity Due Diligence
• Establish a due diligence process for supporting portfolio’s liquidity targets
• Example: Liquidity Estimator – Three year historical look back by month – Lowest month for collections (incl. portfolio) – Highest month of disbursements – Lowest bank balance net is your liquidity floor. – Liquidity level is X times your liquidity floor
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Interest Rate Risk
• Interest rate risk quantifies a public funds willingness to take principal risk in pursuit of a market rate of return (#3 policy objective)
• The Plan’s duration is a risk constraint chosen to reflect how much the principal value of the portfolio will be expected to change with changes in interest rate risk (not total return).
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GFOA Sample Investment Policy
Yield: “The investment portfolio shall be designed
with the objective of attaining a market rate of return throughout budgetary and economic cycles taking into account the investment risk constraints and liquidity needs.”
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Market Rate of Return
• Market Rate of Return: 12-month moving average of the 2yr USTN auction yield.
• Adapts to the fiscal year budget cycle
• Unlike total returns, a market rate of return when compared to portfolio purchase yield produces a more stable and realistic snapshot of portfolio performance within budget cycle
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(6.00)
(4.00)
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
08/3
1/98
- 08
/31/
99
02/2
8/99
- 02
/29/
00
08/3
1/99
- 08
/31/
00
02/2
9/00
- 02
/28/
01
08/3
1/00
- 08
/31/
01
02/2
8/01
- 02
/28/
02
08/3
1/01
- 08
/31/
02
02/2
8/02
- 02
/28/
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08/3
1/02
- 08
/31/
03
02/2
8/03
- 02
/29/
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08/3
1/03
- 08
/31/
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02/2
9/04
- 02
/28/
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08/3
1/04
- 08
/31/
05
02/2
8/05
- 02
/28/
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08/3
1/05
- 08
/31/
06
02/2
8/06
- 02
/28/
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08/3
1/06
- 08
/31/
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02/2
8/07
- 02
/29/
08
08/3
1/07
- 08
/31/
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02/2
9/08
- 02
/28/
09
08/3
1/08
- 08
/31/
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Tota
l Ret
urn
Date
Total Return Component Analysis: 1Yr Annualized Returns 1YrTotRtnAnn-G1A0
1YrPrcRtnAnn-G1A0 1YrCpnRtnAnn-G1A0 12MoMovAvg-G1A0
Focus on Budget Stability
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Designate Strategic Portfolios
Primary – Secondary – Income
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Constructing PC Portfolio
1. Divide total investment portfolio – Strategic liquidity – Income portfolio.
2. Divide strategic liquidity – Primary liquidity – Secondary liquidity
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Orange County, CA When Practice Didn’t Follow Policy
• Putting all your liquidity eggs in one basket makes a basket case
• Diversify (more than one) primary liquidity
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• Liquidity focused solely on insuring cash management is able to meet current obligations without prematurely selling a security; absolutely no market risk
• Liquidity positioned to convert a security or investment to cash at or near it’s original cost or NAV; no principal loss
Primary Liquidity 0-Days
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Secondary Liquidity 1-360 Days
• CYA liquidity “expects the unexpected”
• CYA liquidity allows portfolio manager to combine diversification of liquidity with a focus on income enhancement (Rated 3c-7 or 1.00 NAV funds)
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• Liquidity Rule #1: Diversification • Liquidity Rule #2: Divide • Liquidity Rule #3: Job Risk
Job risk is forgetting liquidity rules 1 & 2
Cash Management Rules
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Creating Income Portfolio
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Diversification Suitable diversification will focus on two
critical measures, liquidity and issuers.
1. State Pools should not be the only source for primary liquidity
2. Individual security holdings should not exceed XX % of portfolio market value
3. Individual corporate issuers other than federal agency’s should not exceed XX % of portfolio holdings
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Income Portfolio
Total Portfolio – Strategic Liquidity = Income Portfolio
100 % – 30 % = 70 %
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Income Portfolio • Income portfolio represents the core
investment portfolio. • Optimizing income not liquidity is the key
characteristic of a income portfolio. • Minimizing risk means minimize principal
risk. For public funds this means enhance income with minimum price volatility.
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Income Politics
Why should each public fund portfolio manager expect to recognize a principal loss?
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Because the investment policy mandates it!
Avoiding risk is
not managing risk!
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Why have Yield as an investment policy objective?
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1. Offer more public services 2. Cover operational cost 3. Mitigate tax burden
To Satisfy the Public’s Three Most Wanted List
Concluding Thoughts “performance reporting”
Ø The key question to be answered - is the
portfolio manager a good steward of the public’s money?
Ø How good is the portfolio manger at both protecting principal and earning a reasonable market rate of return?
Performance Measurement “quantifying stewardship”
Ø The key distinction of a fiduciary benchmark or investment plan is it will capture all policy objectives in policy priority.
Ø The plan or fiduciary benchmark measures performance in the context of not only what is legal but also what is suitable.
Suitability 1. Sufficient liquidity to pay obligations without selling a
security before maturity
2. Portfolio maintains the appropriate level of interest rate risk
3. Portfolio is diversified (no concentration risk)
4. Portfolio holdings are legal
5. Portfolio earns a market rate of return
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