Beyond Total Return Introduction to Developing A Fiduciary Benchmark 2016 GIOA Preconference Part II Benjamin Finkelstein, CFA befinkelstein@cantor.com Cantor Fitzgerald 8,5 6,75
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. Ø Be able to identify and explain what characteristics differentiates a Public Fund from a Pension Fund. 8,5
When managing a public fund portfolio what is the most important skill you can develop? 8,5 6,75 3
Communication Skill 8,5 6,75 4
Standard of Care - Prudence The standard of prudence to be used by investment officials shall be the “prudent person” standard and shall be applied in the context of managing the overall portfolio. The "prudent person" standard states that, “Investments shall be made with judgment and care, under circumstances then prevailing, which persons of prudence, discretion and intelligence exercise in the management of their not for speculation but for investment, considering own affairs, the probable safety of their capital as well as the probable income to be derived.” GFOA Sample Investment Policy
Standard of Care - Prudence Investment officers 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. GFOA Sample Investment Policy
THE POLITICS Ø Total Return Peer Groups Ø GASB 31 Ø 8,5
‘ 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%.” Total Return
‘ 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. Peer Groups
‘ News Reporter: “Madam Treasurer, how can you claim to be a good steward of the public’s money while showing a reported loss?” GASB 31
Observation #1– Total Return Is beating a market index on a total return basis a measure of good stewardship? Is reporting a negative total return a measure of poor stewardship and a failure to preserve principal? 8,5
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 ? 8,5
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? 8,5
The previous three observations leads one to ask . . . . . Are current performance measures really effective at measuring a public funds performance? Let’s try the following exercise 8,5
Rank The Risk Safety 40 % Liquidity 40 % Yield 20 % Total 100 % 8,5
What is the most frequently asked question about your portfolio? What is the return? 8,5
GFOA Sample Investment Policy Objective - 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. Return is of secondary importance compared to the safety and liquidity objectives. 8,5
So.... How can public fund’s accept that investment practice follows policy, when the performance measures used emphasize only one policy objective that policy objective is (return) and explicitly stated to be of secondary importance? 8,5
If investment practice is not following policy and the current performance measures offer limited benefits then what's the solution? Develop a Fiduciary Benchmark 8,5
Quick History Lesson Orange County Bankruptcy Lesson 1: Legal does not mean Suitable Safe does not mean Liquid Lesson 2: Diversification is not enough Lesson 3: 8,5
Should a public fund manage money like Wall Street? 8,5 6,75
Developing A Fiduciary Benchmark Step 1: What performance should be evaluated? Stewardship Step 2: What performance measure or measures are most helpful in evaluating stewardship? 8,5 Suitability
Developing A Fiduciary Benchmark Step 3: What does the investment policy describe and what role does it play? 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 8,5
Developing A Fiduciary Benchmark Step 5: What is the only Peer Group for a public fund? The Investment Policy Step 6: What five measures quantify suitability? *We have enough liquidity to pay current obligations 1 *We have an appropriate level of interest-rate risk *We have a diversified portfolio 2 8,5 *We own only legal investments *We are earning an appropriate market rate of return 3
Benchmarking Stewardship Investment Policy describes Investment Plan describes what is legal. what is suitable. It is the Rule Book. It is the Play Book. Policy Plan Portfolio The Investment Policy The investment Plan is a public funds sole serves as the portfolio’s Peer Group. Fiduciary Benchmark. A Fiduciary Benchmark serves as a performance measur e for stewardship . It quantifies the suitability of a public funds portfolio. 25
Philosophy : a theory or 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. 8,5
The Principle Choices u Market Index ² Fiduciary Index u One Policy Objective ² All Policy Objective u Total Return ² Market Rate Return u Growth ² Income u Trader ² Investor u Active ² Passive
Are Public Funds Pension Funds? No! Scope This policy applies to the investment of short- funds. Longer term funds, term operating including investments of employee’s retirement funds and proceeds from certain bond issues, are covered by a separate policy. GFOA Sample Investment Policy
The Principle Choices cont’d u Market Index ² Fiduciary Index u One Policy Objective ² All Policy Objective A benchmark is adopted to proxy reality. For public funds its not just securities that should be equally important is the need to measured, 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 .
Have you failed in your fiduciary duty to protect principal whenever you report a recognized but unrealized loss? No 8,5
Are public funds indifferent to source of returns? Does a public fund typically budget paper gains or losses? Normally No 8,5
The Principle Choices cont’d u Total Return ² Market Rate Return “Total rate of return measures the increase in the investor’s wealth due to both investment income and (realized or unrealized). The total rate capital gains of return implies a dollar of wealth is equally meaningful to the investor whether the wealth is generated by the secure income from a 90-day or by the unrealized appreciation in the Treasury Bill price of a share of common stock.” Managing Investment Portfolios: A Dynamic Process (CFA Institute)
The Principle Choices cont’d ² Income u Growth 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 not for speculation management of their own affairs, but for investment, considering the probable safety of their capital as well as the probable income to be derived.” GFOA Sample Investment Policy
The Principle Choices cont’d u Growth 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 of stocks that are expected to increase quickly in price.
The Principle Choices cont’d u Trader ² Investor u Active ² Passive *Trader actively invests in a bond with the intention of 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.
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