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Beyond Total Return
Introduction to Developing A Fiduciary Benchmark
2016 GIOA Preconference Part II
Benjamin Finkelstein, CFA befinkelstein@cantor.com Cantor Fitzgerald
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Ø Be able to identify and explain what characteristics differentiates a Public Fund from a Pension Fund.
Session Objectives
Ø Understand the issues influencing a public fund’s investment strategy and performance. Ø Become familiar with the framework used for developing a fiduciary benchmark.
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When managing a public fund portfolio what is the most important skill you can develop?
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Communication Skill
SLIDE 5 Standard of Care - Prudence
“Investments shall be made with judgment and care, under circumstances then prevailing, which persons
prudence, discretion and intelligence exercise in the management of their
GFOA Sample Investment Policy not for speculation but for investment, considering the probable safety
- f their capital as well as the probable
income to be derived.” The standard of prudence to be used by investment officials shall be the “prudent person” standard and shall be applied in the context
the
The "prudent person" standard states that,
SLIDE 6 Standard of Care - Prudence
GFOA Sample Investment Policy Investment
acting in accordance with written procedures and this investment policy and exercising due diligence shall be relieved of personal liability for an individual security’s credit risk or market price changes, provided deviations from expectations are reported in a timely fashion and the liquidity and the sale of securities are carried out in accordance with terms of this policy.
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THE POLITICS
Ø Total Return
Ø
Peer Groups
Ø
GASB 31
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‘
Total Return
Treasurer: “Commissioners I am excited to report the County of Sweet Returns is in the top 1% quartile of all professional money mangers benchmarked to the ML 1- 3 year Government Index. We only lost 2.00% of our citizens money compared to our Merrill Lynch benchmark that lost 2.50%.”
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‘
Peer Groups
There are two counties located in the same state with the same size portfolio’s. Both comply with their state’s statues and share the exact same investment policy objectives of safety, liquidity and yield. One county reports a higher yield. Peer Group comparison would suggest the portfolio manager with higher yield is the better manager.
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GASB 31 News Reporter: “Madam Treasurer, how can you claim to be a good steward
the public’s money while showing a reported loss?”
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Observation #1– Total Return
Is beating a market index on a total return basis a measure
good stewardship? Is reporting a negative total return a measure of poor stewardship and a failure to preserve principal?
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Observation #2– Peer Group
Is a county with a higher reported return actually a better steward of the public’s money then a similar county with a lower return?
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Observation #3– GASB 31
Is a reported market value loss indicative of poor stewardship? Is a reported market value gain indicative of good stewardship? Is GASB 31 a reporting standard or a performance measurement?
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Are current performance measures really effective at measuring a public funds performance? The previous three observations leads one to ask . . . . . Let’s try the following exercise
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Rank The Risk
Safety Liquidity Yield Total 40 % 40 % 20 % 100 %
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What is the return?
What is the most frequently asked question about your portfolio?
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GFOA Sample Investment Policy Objective - Yield
The investment portfolio shall be designed with the objective of attaining a market rate
return throughout budgetary and economic cycles taking into account the investment risk constraints and liquidity needs. Return is
secondary importance compared to the safety and liquidity objectives.
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How can public fund’s accept that investment practice follows policy, when the performance measures used emphasize
policy
(return) and
So....
that policy
explicitly stated to be
secondary importance?
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Develop a Fiduciary Benchmark
If investment practice is not following policy and the current performance measures
limited benefits then what's the solution?
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Quick History Lesson
Orange County Bankruptcy Lesson 1: Lesson 2: Lesson 3: Legal does not mean Suitable Safe does not mean Liquid Diversification is not enough
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Should a public fund manage money like Wall Street?
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Step 1: What performance should be evaluated?
Developing A Fiduciary Benchmark
Step 2: What performance measure or measures are most helpful in evaluating stewardship? Suitability Stewardship
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Step 3: What does the investment policy describe and what role does it play?
Developing A Fiduciary Benchmark
Describes what’s legal - Role is the Rule Book
Step 4: What does the Investment Plan describe and what role does it play?
Describes what’s suitable – Role is the Play Book
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Step 5: What is the only Peer Group for a public fund?
Developing A Fiduciary Benchmark
*We have enough liquidity to pay current obligations1 *We have an appropriate level of interest-rate risk *We are earning an appropriate market rate of return3 *We own only legal investments *We have a diversified portfolio2
The Investment Policy Step 6: What five measures quantify suitability?
SLIDE 25 Benchmarking Stewardship
Policy
A Fiduciary Benchmark serves as a performance measure for stewardship. It quantifies the suitability of a public funds portfolio.
Investment Policy describes what is legal. It is the Rule Book. The Investment Policy is a public funds sole Peer Group. Investment Plan describes what is suitable. It is the Play Book. The investment Plan serves as the portfolio’s Fiduciary Benchmark.
Plan Portfolio
25
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Philosophy: a theory
attitude held by a person or organization that acts as a guiding principle for behavior. (Webster Dictionary) Whatever is chosen as a benchmark serves as the framework for how to evaluate a public funds investment performance and behavior.
SLIDE 27 The Principle Choices
uMarket Index uOne Policy Objective uTotal Return uGrowth uTrader uActive ² Fiduciary Index ² All Policy Objective ² Market Rate Return ² Income ² Investor ² Passive
SLIDE 28 Are Public Funds Pension Funds? No!
GFOA Sample Investment Policy
Scope
This policy applies to the investment of short- term
- perating
- funds. Longer term
funds, including investments of employee’s retirement funds and proceeds from certain bond issues, are covered by a separate policy.
SLIDE 29 uMarket Index uOne Policy Objective
The Principle Choices cont’d
² Fiduciary Index ² All Policy Objective
A benchmark is adopted to proxy reality. For public funds its not just securities that should be measured, equally important is the need to measure a public fund’s investment behavior, that is how good a steward was the entity at managing a suitable balance between principal preservation, liquidity and income.
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No
Have you failed in your fiduciary duty to protect principal whenever you report a recognized but unrealized loss?
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Normally No
Are public funds indifferent to source
Does a public fund typically budget paper gains or losses?
SLIDE 32 uTotal Return
The Principle Choices cont’d
² Market Rate Return
“Total rate of return measures the increase in the investor’s wealth due to both investment income and capital gains (realized or unrealized). The total rate
return implies a dollar
wealth is equally meaningful to the investor whether the wealth is generated by the secure income from a 90-day Treasury Bill
Managing Investment Portfolios: A Dynamic Process (CFA Institute)
appreciation in the price of a share of common stock.”
SLIDE 33 uGrowth
The Principle Choices cont’d
² Income Standard of Care – Prudent Person
“Investments shall be made with judgment and care, under circumstances then prevailing, which persons of prudence, discretion and intelligence exercise in the management
affairs,
GFOA Sample Investment Policy
not for speculation but for investment, considering the probable safety of their capital as well as the probable income to be derived.”
SLIDE 34 uGrowth
The Principle Choices cont’d
² Income Bloomberg Financial Dictionary:
*Income Portfolio: Group of securities designed to provide high short-term income as opposed to long- term growth.
*Growth Portfolio: A securities portfolio comprised
- f stocks that are expected to increase quickly in
price.
SLIDE 35 uTrader uActive
The Principle Choices cont’d
² Investor ² Passive
*Trader actively invests in a bond with the intention
- f selling before maturity to profit from a change in
price (capital appreciation). *Investor passively seeks to take advantage of market and structure premiums. Does not “intend” to sell before maturity to profit from a price movement in the bond.
SLIDE 36 For public funds accountability is a top priority.
Summary
Evaluating a public fund's performance requires insight into not only the portfolio holdings but the investment behavior responsible for constructing and managing the investments. A Fiduciary Benchmark properly constructed will not only insure investment practice follows policy but offers five performance measures for a true accounting of the public fund’s stewardship.
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Q&A
Warren Buffet’s Million Dollar Bet
I thought Buffet was the “Patsy a the poker table.”
SLIDE 38 Disclaimer
The information herein has been obtained from sources Cantor Fitzgerald and Co. (Cantor) believes to be reliable, but Cantor does not represent or warrant that it is accurate or complete. This information has been prepared solely for informational purposes. It is not an endorsement of, or a solicitation to purchase, any of the products or services mentioned herein. Cantor disclaims all liability for the accuracy or completeness of the information provided by any vendors or contained in any websites mentioned herein.
