Feature Articles and Resources

• Investing Through Benchmarking
  
• Public Investor 10-Bill Index
  
• Recommended Practice on Investment Reporting
  
• What is a Benchmark?
  
• Common Benchmarks
  

• Panel of Economists: Economic Forecasts
  
• Interest Rate Outlook
  
• Economic and Interest Rate Data

• Performance Benchmarks
  • 10-Bill Index
  • Money Market Fund Index
  • LGIP Index
  • Key Rates: Cash Markets
  • Relative Value Yield Chart

Investing Through Benchmarking

How are your investments performing? What is happening to the principal value of your portfolio when interest rates change? What are the appropriate risk and returns that can be expected for the types of funds you are investing? Did your portfolio perform up to expectations? How were these expectations derived and communicated? The answers to these questions and many more are an integral part of effective investment management. Benchmarking is the process that provides performance analysis and creates a method to communicate expectations and results.

Public fund investors are confronted with many challenges including uncertain cash flows, volatile interest rates, regulatory changes, and fiduciary responsibility. Public fund objectives require that liquidity needs be satisfied while preserving capital and simultaneously achieving market rates of return. Most governmental entity investment policies identify the objectives and the securities used to meet these objectives. However, seldom do such policies establish a process or a procedure to monitor risk and measure returns. Benchmarking is a step in the investment management process that addresses risk management, yield enhancement, and the monitoring of investment returns versus expectations.

What is a benchmark? A benchmark is a composite of securities with specific maturity and asset class characteristics that represent a portion of the financial market universe. Investors can simulate the expected risk and return of various benchmarks to determine the most appropriate structure for their portfolio. A benchmark index has the following characteristics:

1. Contains a composite of securities maintained within specific parameters
   
2. Provides information
   
3. Is rule-based, not managed
   
4. Can be measured
   
5. Remains relatively stable in regards to duration and asset allocation.

How do you use a benchmark? Investors use benchmarks to assess the performance of their portfolio and to oversee incremental changes to that portfolio.

Example of benchmarks. Many short-term public fund investors use the Treasury one- to three-year index as a benchmark for core balances, because it reflects the maturity structure, quality, and market exposure consistent with their investment objectives and policy. The Treasury one- to three- year index is a composite measurement of every U.S. Treasury note in the market from one year to three years in maturity. Several firms provide this type of index.

History illustrates that, over longer periods of time, having investments exposed longer out on the yield curve results in greater returns, but this comes with a risk of periodic market price declines that must be considered when determining appropriate exposure. The Treasury one- to three-year index portfolio has provided approximately 94 basis points of additional return relative to the three-month bill over the last 10 years. We believe the best risk-adjusted returns for conservative investors with relatively low price volatility comes from this sector of the curve. In addition, the 1.8 year average maturity of the index falls within the guidelines of most investment policies and is an appropriate exposure for public fund idle cash balances. It is important to note that this type of benchmark is appropriate for idle funds (core funds) not for funds needed for liquidity purposes (liquidity funds).

Decision-making Using a Benchmark. An investor’s portfolio structure is adjusted relative to the benchmark depending on the market outlook or the entity’s specific needs. We suggest establishing a minimum and maximum exposure (duration) around the benchmark as part of the strategy to achieve enhanced market rates of return. As new money is available, the maturity selection of the new investment would be dictated by the current and targeted overall portfolio exposure (duration) relative to the benchmark.

Is outperforming the benchmark the key to this process? No. The key to the process is to establish a disciplined approach to placing investment funds out longer on the yield curve so as to enhance returns over longer periods of time, while controlling risk. The goal is not to significantly outperform the index, but to achieve the return of the index or enhance it by using conservative portfolio management tools. These tools may include the following:

• Either being shorter or longer than the duration of the benchmark. An acceptable difference between the duration of the benchmark and the portfolio is predetermined. The greater the acceptable range around the duration of the benchmark, the greater the return variable.
  
• Investing at a particular point on the yield curve. A barbell structure (combination one-year notes and three-year notes) will outperform a benchmark when the yield curve flattens and a bullet structure (all two-year notes) will outperform a benchmark when the yield curve steepens.
  
• Investing in asset classes outside the benchmark issues; e.g., adding U.S. agency obligations or asset-backed securities to a generic U.S. Treasury portfolio. This tool should be considered after credit quality variation is taken into account.

Are there other benefits to benchmarking? Yes. The benchmarking process provides a discipline to the investment management process and helps reduce the “shoot from the hip” syndrome to emotional swings in the market. But most importantly, it communicates to all the expected returns and risk associated with the portfolio based on the historical performance of the benchmark and the acceptable level of variance from the benchmark. This process will reduce the probability of results that are significantly outside an expected range, which should enhance the risk management process for those with fiduciary responsibilities.

Benchmarking provides the public fund investor with a clear sense of direction, accountability, and tools to balance risk and return. This disciplined strategy can be clearly communicated to pool participants, boards, and other interested parties. This increase in communication alone is a significant step in the development of the investment management process.

Investment advisors are available to assist internal investment officers in designing, managing, and reporting portfolio characteristics relative to the appropriate benchmark. Most public fund advisors are sensitive to implementing a cost beneficial relationship in providing these types of services.

Deanne Woodring, CFA, and Dave Westcott, CFA, are managing directors, and Sally Walton is a vice president of Davidson Fixed Income Management.

Public Investor 10-Bill Index

The Public Investor 10-Bill Index is a portfolio benchmark that simulates the cash flow demands of a typical government with biweekly payrolls and other cash requirements. To create a portfolio of securities that generates income every two weeks, the 10-Bill Index contains a synthetic portfolio of 10 Treasury bills. The maturity dates are staggered so that one of the 10 bills matures every two weeks. The portfolio has an average maturity of approximately 12 weeks or 83 days.

Because the 10-Bill index is based on riskless Treasury bills, it should provide a minimum performance standard for the average government cash management portfolio. Investors who purchase bank CDs, commercial paper, and federal agency securities should be able to consistently outperform this index because those yields should be higher to compensate for the higher credit and liquidity risk.

Recommended Practice on Investment Reporting

In public investment portfolios, one of the greatest risks for potential loss lies in the fluctuation of market value for securities in that portfolio. Over time, reporting standards for state and local government investment portfolios have been enhanced so that investors, governing bodies, and the public remain informed of the current market value of the portfolio. Regular disclosure of the value of a governmental entity's investments is an important step to furthering taxpayer and market confidence in state and local government investment practices. Government officials should be aware of state, local, accounting, and rating agency requirements regarding mark to market practices.

The GFOA recommended practice “Mark-to-Market Reporting Practices for State and Local Government Investment Portfolios and Investment Pools” recommends that state and local government officials responsible for investment portfolio reporting determine the market value of all securities in the portfolio on at least a quarterly basis. These values should be obtained from a reputable and independent source and disclosed to the governing body or other oversight body in a written report on at least a quarterly basis. The independent source of pricing should not be one of the parties to the transaction being valued and could include:

1. a broker or other financial institution who was not a counterparty to the transaction,


2. the custodial bank if the bank was not a counterparty to the transaction,


3. publicly available publications such as the Wall Street Journal, or


4. other pricing services for which a separate fee would be paid.

The written report should include the market value, book value, and unrealized gain or loss of the securities in the portfolio.

If there is a significant event in the local or national economy that might affect the value of the portfolio, then a mid-term valuation of the portfolio should be conducted. Governments that employ a more active portfolio management style should consider more frequent marking to market and reporting.

Many state and local government officials are allowed to invest in various state and local government investment pools available in their state or region. GFOA recommends that pool administrators, on a daily basis, determine the market value of all securities in the pool and report this information to all pool participants on at least a monthly basis. These values should be obtained from a reputable and independent source. This information should be included in the report to the governing body prepared on at least a quarterly basis.