Tumultuous global financial markets over the past year have wreaked havoc on public entities, decimating the financial status and reputations of many state and local governments. As a result, the stewards entrusted with managing taxpayers’ funds face increased scrutiny.
Being a good steward means demonstrating that the government’s investment strategy and portfolio are appropriately balanced between protecting the principal, providing sufficient liquidity to meet cash flow needs and achieving a fair rate of return and investment income within defined risk parameters of the fund. Public fund managers can no longer attempt to outsource the knowledge required to participate in capital markets. Internal or outsourced investment management requires stewards who understand and monitor the investments, even if the investments are in the local government pool.
Given the ever-increasing complexity within financial markets, it is time for public fund managers to move beyond their government’s investment policy and establish an investment plan that provides a metric of successful stewardship. The concept of an “Investment Plan” is described in Ben Finkelstein’s book, “The Politics of Public Fund Investing,” and in a course he teaches through the Bethesda, Md.-based Public Treasury Institute, www.publictreasuryinstitute.com. An investment plan serves as the road map for implementing a fund’s investment policy and as a benchmark to measure “suitability” of investments. The premise is that public funds are not total return investment portfolios as defined by Wall Street; therefore, their performance cannot be captured appropriately by Wall Street metrics alone. Each public fund is unique, with its own constraints that are not captured by Wall Street benchmarks. The Investment Plan is the benchmark to measure a disciplined investment process that includes: sufficient liquidity; credit and interest rate risk within the risk tolerance defined by the investment policy; diversification of asset classes and issuer concentration; investments that are legal as defined by state statute; a demonstration that the portfolio is earning a market rate of return; and indication of potential drift beyond parameters of suitability.
In addition, public fund managers need to implement an internal process for vetting investments and managing credit and interest rate risk. Public fund managers have the fiduciary responsibility to understand the analysis behind credit ratings. The national rating agencies — Moody’s, Standard & Poor’s and Fitch — provide detailed research of their rating process. Most brokers provide research on the securities and asset classes they sell. Likewise, investments with imbedded call options or structural risk must be understood to gauge the potential effect the risk may have on a fund’s liquidity. Public fund managers must be familiar with and use all available research tools to measure and monitor the credit and interest rate risk in their portfolios.
The credit crisis has exposed both the private and public sectors’ lack of investment due diligence and over-reliance on the national credit rating agencies for choosing investments. It is public fund managers’ fiduciary responsibility to improve stewardship by employing a disciplined investment process for allocating taxpayer dollars.
The author is deputy director of investments for Seattle and vice president of the Government Investment Officers Association.