Portfolio Management

Individuals assigned the responsibility for managing the cash reserves of public entities often are entrusted with a tremendous amount of discretionary authority. Ideally, the fund manager should possess both formal education and related experience in investment banking, financial counseling, or related fields. A strong track record is a must. Equally important are positive character traits and a demonstrated practice of using good common sense.

A fund manager may single-handedly lead a government to financial ruin if bad investments are made. From that perspective, a fund managers has more potential to do harm to a government than does the chief executive officer. For that reason, public officials must exercise considerable caution when selecting a fund manager.

Over the past several years, the standards of discretion for fund managers have changed, in some cases considerably so. Several states have adopted legislation regulating the amount of discretionary authority that can be granted to fund managers. The gist of these laws is that fund managers are expected to handle public funds in a responsible, generally conservative, manner so as to minimize the likelihood of loss of principal. A fund manager should exercise extreme caution when considering investments where even a remote possibility of loss of principal exists.

On the other hand, a fund manager may be held accountable if the funds are invested in such a conservative manner that the earning potential of the funds is not maximized. The mix of investments entered into by the manager must be appropriate to the fiscal condition of the entity represented and must take into consideration the status of the state and national economy.

Maximize Yield/Minimize Risk

The fundamental objective of cash management is to maximize yield and minimize risk. To this end, public officials need to formulate an investment strategy that reflects the overall objectives of the community and can be applied to govern the actions taken on a day-to-day basis.

The first step is to determine available funds. Cash flow projections should be made to reflect the impact of various economic conditions on the overall availability of funds for investment. An intervening credit crunch and high interest rates, for example, may cause suppliers to shorten their credit terms and to press for more prompt payment of invoices. Conversely, cheap credit and lower interest rates may ease supplier terms. Information on these broader conditions should enable the fiscal manager to arrive at reasonable predictions as to how much money will be available to invest, and for how long.

The next step is to formulate a policy on investments. As suggested earlier, many public officials tend to overemphasize safety and, as a result, invest in securities with relatively low rates of return. In formulating an investment policy, the financial manager should investigate the investment instruments available in the market, determine their relative yields for the maturities required, and evaluate the difference in risk associated with them. On the basis of this evaluation, a policy should be developed and submitted to a finance committee for review and approval. In this way, the financial manager can attain broader counsel on the implementation of an appropriate investment policy, gain insight, and decrease personal liability.

Building an Investment Structure

In general, the longer the maturity of an investment, the higher the yield. For this reason, it is important to design an investment pattern whereby each security will mature close to the time when the money invested will be needed to cover operational needs. For example, a locality may determine through its forecasts that a given sum of money will be available for a 90-day period. This amount may be invested in, say, 90-day commercial paper. Another sum, available for only thirty days, might be invested in a certificate of deposit. In some cases, funds may be available for only a day or a week at a time. These funds might be invested in repurchase agreements or other securities that can be held for indeterminate periods.

The number of days involved in interest rate calculations can be determine in a number of ways. Therefore, it is important for the portfolio manager to know the basis on which interest rate calculations are being made for any given investment opportunity. These "day count" conventions were devised before the wide spread use of computers to simplify the math involved in performing complex financial calculations. And as in most industries with long histories, many of these conventions have remained in use despite the considerable advances in computers and computational methods. A widely used convention is to assume that each of the 12 months in a year consist of exactly 30 days, so that the interest earned in one month is equal to 30/360 times the annual interest rate (e.g., 30/360 x 5% = 0.41667%). On the other hand, the Actual/Actual convention considers the actual number of days in a month and the actual number of days in a year. The interest earned during the month of July on an investment with an annual rate of return of 5% would be 31/365 x 5% = 0.42466%.

Large local governments may have millions of dollars to invest and may have several employees whose primary responsibility is handling these investments. Smaller jurisdictions may be unable to afford an investment manager because of the relatively small amounts to be invested, often for only a few days at a time. Such localities may authorize their banks to invest automatically any surplus funds in money market funds, certificates of deposit, or other short-term securities.

The inadequacy of resources is a major constraint on the maximization of investment returns. A locality cannot invest in the money market unless it can raise enough revenue to satisfy current obligations and accumulate a surplus. Whereas some local governments are relatively affluent and have large tax bases, others often are hard-pressed to maintain and deliver needed services to their citizens. Thus, central to the issue of optimal return on investment is the question of resources: (1) the availability of surpluses to invest and (2) the technical expertise necessary to manage a portfolio of investments.

Constraints on Public Investments

Investment activities of local governments are regulated by state statutes that are presumed to reflect public policy. Some of these regulations restrict the investment opportunities available to localities, thereby depriving the public of the benefits of efficient investment of public funds. Such regulations were once necessary to control the imprudence of some local officials in the management of public funds. However, more recent developments have tended to render typical state investment laws obsolete:

First, the money markets themselves have become increasingly sophisticated and competitive, with a myriad of financial institutions seeking investment capital through new securities and instruments. Thus, the options available to investment officers have increased dramatically. [5]

Securities are now available with varying levels of risk, investment return, and maturities. Whatever the financial objectives of a locality, a range of appropriate investment strategy are available.

Secondly, the sophistication of state and local government investment officials has grown in the past decade. . . .With increasing specialization and professionalism common throughout the state and local government sector, these public money managers increasingly rival their private sector counterparts in their understanding of investment securities and relative risks and rewards. [6]

At the same time, some local jurisdictions have self-imposed additional restrictions and limitations on their investment policies. Localities have tried to mitigate risk by setting up a variety of investment criteria designed to diversify investment holdings and avoid investments in weak financial institutions. The objective is to identify appropriate eligibility standards, investment limits, and safekeeping requirements. The over-riding goal remains to minimize risk and maximize investment income.

The requirement that banks pledge securities as collateral to secure public deposits and investments imposes excessive costs on the financial institution--costs that are usually passed on to the public entity in the form of reduced rates of return. Experts argue that in the event of wide-spread failures in the banking system, many of the securities used for collateral pledges could prove equally worthless. The positive benefits associated with collateralization become most obvious, however, when a public organization deals with a single financial institution and the institution defaults because of poor management or some other micro-economic factors. A case in point is the 1982 collapse of Penn Square Bank, in which collateralization provisions protected the assets of the state and its political subdivisions. Collateralization is akin to an insurance policy aimed at protecting the safety of public deposits.

The inadequacy of resources is a major constraint on the maximization of investment returns. A locality cannot invest in the money market unless it can raise enough revenue to satisfy current obligations and accumulate a surplus. Whereas some local governments are relatively affluent and have large tax bases, others often are hard-pressed to maintain needed services to their citizens. Larger localities may have millions of dollars to invest and may assign several employees to handle these investments. Smaller jurisdictions may be unable to afford an investment manager because of the relatively small amounts to be invested, often for only a few days at a time. Such localities may authorize the banks that hold their accounts to automatically invest any surplus funds in certificates of deposit or other short-term securities. Some smaller jurisdictions have minimized risk by joining state-managed investment pools. These pools resemble money market mutual funds in their portfolio composition and provide professional management, diversification, and money market rates of return on liquid assets. State investment pools provide competition and often superior yields to local depository institutions.

Exogenous Factors

Exogenous factors may be more important in determining investment yields than the characteristics of the investment instruments themselves or the ability of the local government to accumulate resources for investment. Maturity dates are an important determinant in choosing investments. Suppose, for example, that an investment officer deter-mines that about $500,000 will be available for investment from May 1 to June 10. After taking bids from several banks and brokers, a list of maturity dates and yields is developed, as follows:

Although the banker's acceptances and repurchase agreements offer the highest yields, their maturity dates occur after June 10, when the principal must be available for other uses. The CD has the lowest yield, but may be considered the best alternative because it matures prior to the June 10 date. The T-bills mature on June 11 and may be the best choice, depending on the possibility of a one-day leeway in the need for these invested funds. Although the amount available for investment is substantial, the primary consideration may be the maturity date of the investment, despite a smaller yield than might be considered optimal.

Wide fluctuations in interest rates over the past several years. It is important for a fiscal manager to understand how these fluctuations can affect investment decisions. The manager should endeavor to predict the interest rate cycle and use those predictions in managing the jurisdiction's investments.

It may be determined, for example, that $125,000 is available for investment during a 179 day period, after which the principal and interest will be applied to finance a capital improvements project. After taking bids from several investment firms and banks, the manager decides to invest the funds at 5.15 percent. No consideration is given to the possibility that interest rates could be rising, and investment is "locked in" at 5.15 percent. The expected yield on this investment (using the Actual/Acutal convention) is:

$125,000 x 0.0515 x 179/365 = $3,157

Instead of locking in the investment for the full 179 days, the fiscal manager could have decided to purchase a short-term CD and to reevaluate the movement of interest rates at its maturity. The rate bid for a 30-day CD is 5.075 percent; therefore, the expected yield for the 30 days is $521.40. At the end of 30 days, bids are again sought and the following quotations received:

14 to 29 days 5.45%

30 to 59 days 5.88%

60 to 89 days 5.95%

A new CD might be purchased for another 30 days at 5.88 percent, with the expectation of a further evaluation of the interest rate situation at the end of that time. The expected yield for this 30-day period on $125,521.40 (i.e., $125,000 + $521.40 interest) is $606.63 Assume that at the end of the second 30-day period, the interest rates have peaked. At that time, the cash manager decides to "lock into" the current rate of 6.58 percent for the remaining 119 days. The expected interest yield on the $126,128.03 ($125,521.40 + $606.63) is $2,705.77. Thus, the total interest earned under this managed approach would be $521.40+ $606.63 + $2,705.77, or $3,833.80. This yield is $676.80 more than under the initial approach. This second approach also creates a measure of liquidity to respond to unexpected cash flow problems.

An Investment Matrix

An investment matrix for local government is presented in Exhibit 3. Each political subdivision has its own economic and fiscal environment. Characteristics refer to broad sets of circumstances that reflect the economic and fiscal environment of a given jurisdiction. Emphasis suggests the element elements to which fiscal managers may attach the greatest importance, given the stated characteristics. Investment options identify the types of investments that best "fit" the characteristics and emphasis used to describe a particular jurisdiction.

It is important that the yield-liquidity-safety mix be considered in every investment decision. The degree of emphasis placed on any particular element is a function of the fiscal and economic circumstances confronting the locality. When the resources of a jurisdiction are limited, yield cannot serve as the primary objective because high-yield securities usually have correspondingly higher risks associated with them. A resource-limited community must be more concerned with the safety of its investments and its ability to convert these investments to cash on short notice. A small, rural jurisdiction, with relatively limited resources:

cannot afford the luxury of losing any part of its principal investment. As a result of its concern for security, its investment options are limited to securities with rapid convertibility to cash so that the ability of the jurisdiction to undertake major capital expenditures is not handicapped by funds being tied up in non-maturing financial assets. [7]

The investment options available under such circumstances are determined by the safety-liquidity considerations. The investment of such localities, of necessity, are concentrated in low-risk, low-yield securities, such as T-bills, agency securities, and participation in state investment pools. The locality is forced to accept a level of yield that is not optimal as a trade-off for the safety of its investments, while at the same time, retaining the leverage to convert its investments easily to cash if the need arises.

Jurisdictions having appreciably larger annual budgets, larger population bases, and professional management staffs are likely to be more aggressive in their investment strategies. While their strategies pay adequate attention to safety and liquidity, the yield of investments is pursued with greater intensity, often resulting in rates of return 2 to 4 percentage points higher than smaller jurisdictions. [8]

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A third category of jurisdictions can be identified that have enormous amounts of expendable and investable resources.The annual budgets of the jurisdictions in this category are beyond the billion dollar mark; their daily cash balances and investable amounts run into several millions; and their investment realize rates of return between 11 and 12.99 percent. [9]

Investment models adopted in these localities are designed to predict the movement of interest rates over time, thus enabling financial managers to ride the interest rate curve with their investments. These jurisdictions are not threatened by cash flow problems, but have a steady inflow of revenue through taxes, fees, and transfers. As a consequence, financial assets can be structured to emphasize high-yield, long-term securities.

The failure in the 1980s of several investment companies specializing in government securities, combined with the more recent near bankruptcies of several local governments resulting from highly speculative investments, has forced financial managers to rethink their investment strategies and has lead to a renewed emphasis on the safety of local government investments. In the 1980s, investment companies bought securities from savings and loan associations seeking to raise cash temporarily, then sold these securities as repurchase agreements to local governments with idle cash to invest. The local governments that lost money in these incidents neglected a cardinal rule of investment: get possession of the securities. They allowed the dealers to retain control of the securities, and some of these dealers, in turn, pledged the same securities to other investors. State laws guiding public investments generally require localities to take physical possession of investment securities as well as collateral.

The structure of many local governments is not consistent with the maximization of returns in cash management. Some local officials do not see the utility of "gambling" with the taxpayers' money and prefer to leave surplus funds secured on deposit with banks. To the extent that these funds are not invested, returns cannot be optimized. In addition, several procedural requirements often are attached to cash management in local government, including:

(1) A requirement that cash managers obtain prior approval before an investment security is bought or sold.

(2) A requirement that written quotations be obtained for all investment purchases.

(3) Prohibitions on the use of wire transfers for investment transactions.

(4) Restrictions that narrow the range of potential money market instruments.

Legal constraints influence the formation of baking relations, the level of bank compensating balances, and the safety-liquidity requirements of the securities in which a local government may invest. Local governments often cannot achieve optimal returns on their investments because they are not at liberty to use their discretion in investing in securities that meet their individual needs.

Political constraints are evident in several forms, including prohibitions against the use of nonlocal banks or investing outside the local area and the practice of sharing deposits among all banks in the community. The primary argument in support of these prohibitions is the notion of "keeping the money at home." As long as investments are limited to local options, however, local governments may be foregoing higher interest rates available in other markets.

Summary and Conclusions

Safety of principal is an important component of any investment strategy. Concerns about safety, which had diminished over the previous decade, have again been raised as a result of several recent governmental investment disasters. The renewed state of awareness concerning investment safety has led to the enactment of new legislation in several states. Existing laws: (1) limit banks with which local governments can do business, (2) specify the amounts that can be left on deposit in each bank, and (3) require collateral for uninsured funds. Additional requirements which mandate fund oversight and specify requirements regarding appropriate investment instruments are likely.

In addition, public funds on deposit in commercial banks and savings and loans associations are protected under the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation. Under these circumstances, safety cannot be used as the only measure of an investment strategy. Nonetheless, investment options open to local governments have been proscribed by state laws and by self-imposed local statutes. Local financial managers must operate within these parameters or be in violation of the law.

Liquidity is an important investment consideration, especially when a need for funds occurs unexpectedly. Careful planning and structuring of the portfolio mix, however, will ensure that liquidity is built into the investment strategy. Since various securities mature in 30, 90, 180, or 270 days, one year or even longer, a locality can structure its assets in such a way that securities will mature at the time the funds are needed for other commitments.

Yield, or return on investment, is the paramount criterion for measuring the success or failure of an investment strategy. In the face of continuing demands to provide improved and expanded services, local governments confront (1) the need to expand revenues if these demands are to be met, (2) already heavily burdened taxpayers, and (3) narrow restrictions on their ability to borrow to finance public expenditures. Under these circumstances, local governments can be expected to respond enthusiastically to any source of additional revenue that does not involve increased taxation or additional debt. The financial asset portfolio is such a source, and the net return on investments can be an especially important source of revenue.

In evaluating the effectiveness of investment strategies, safety of principal and liquidity must be balanced against yield. The primary benefits of an investment strategy must be measured in terms of the increased interest earned through the investment of temporarily idle cash.

As we approach the turn of the century, the role of the financial manager is likely to become more complicated, with stronger oversight. Large investments will more likely require approval of finance committees and/or concurrence of investment experts. The role will require more consensus building, self education, and legal understanding.

Endnotes

[1] Public Affairs Research Council of Louisiana, Investment of Idle State Funds (Baton Rouge, La.: Public Affairs Research Council, 1956), p. iii.

[2] Municipal Finance Officers Association, A Treasury Management Handbook for Small Cities and Other Governmental Units (Chicago: Municipal Finance Officers Association, 1979), p. 41.

[3] Rhett D. Harrell and Lisa A. Cole, Banking Relations: A Guide for Local Government (Chicago: Municipal Finance Officers Association, 1982), p. 27.

[4] Frank Pataucci and Michael Lichtenstein, Improving Cash Management in Local Government: A Comprehensive Approach (Chicago: Municipal Finance Officers Association, 1977), p. 59.

[5] Committee on Cash Management, Model Investment Legislation for State and Local Governments (Chicago: Government Finance Officers Association, 1984), p. 6.

[6] Ibid., p. 6

[7] Chukwuemeka O'Cyprian Nwagwu, Cash Management in Local Governments (Blacksburg, Va.: Center for Public Administration and Policy, 1985), p. 203.

[8] Ibid., p. 203-204.

[9] Ibid., p. 204

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