Segment Your Portfolio to Achieve Your Investment Objectives
The primary objectives of public sector investing are always safety, liquidity, and yield or return, in that order. These goals may seem to conflict, however. For example, to ensure safety, adequate liquidity must be maintained to protect against potential losses from unplanned sales. At the same time, being “overly” liquid may depress investment returns. (In upward sloping yield curve environments, typically, longer maturities provide higher yields. By modestly increasing the average maturity or duration of their portfolio, governments should be able to take advantage of the normally positive slope of the yield curve.) While there is no universal right balance, adopting an approach that “segments” the overall portfolio may help ensure that each objective is met, and that they reinforce each other.
In its simplest form, segmenting or identifying segments of the total portfolio can be achieved by:?
- Conducting a simple cash flow forecast.?
- Identifying and using different goals as a guide to apportion the overall portfolio into parts or segments.
- Investing each segment in a way that accurately reflects the segment’s purpose, maturity, and risk profile.
A simple cash flow forecast
A simple cash flow forecast helps determine how much of the overall portfolio, or what portion, must remain liquid. The purpose of this segment, the liquidity segment, is to meet anticipated expenses and obligations, and to provide a comfortable cushion for unexpected expenses, which are inevitable. The remainder of the portfolio—the part that isn’t needed for liquidity purposes—is the core component. A cash flow forecast can show whether this portion is stable, growing, or decreasing over time.
From an investing standpoint, such acash flow forecast does not need to be granular and may focus on as few as three to five categories of revenues and expenses, respectively. Depending on a government’s resources and cash flow sophistication, these components can be further segmented into different layers, depending on timing of liquidity needs, or different objectives for the core component. So a portfolio can comprise two levels of liquidity, a segment or bucket with a timeframe of 30 days or less and a component of intermediate-term liquidity such as six months or less. However, at its most basic, segmentation involves creating two key components of the overall portfolio, a liquidity component and a core segment. These segments will include different investments that accurately align with the government’s desired risk/return profiles.
Even in the relatively short-term reality of public funds investing, broadly speaking, the following characteristics of each segment provide a simple, clear, and useful way to conceptualize segmentation:?
- Liquidity (short-term horizon)
- Cash, typically, used for daily operating needs and likely to be required at very short notice.
- Cushion for unforeseen requirements.
- Typical investment horizon fewer than 12 months
- Objectives: safety and liquidity.
- Core (longer-term horizon)
- No short-term use forecasted.
- Historically, such funds have not been used for ongoing expenses.
- Investment horizon of one year or longer.
- Objectives:safety and return.
The liquidity and core segments, having different objectives, may be invested somewhat differently, subject to state statute and a government’s own investment policy.
The liquidity segment may be invested in investments characterized by short maturities, which tend to exhibit lower volatility. Examples include: short-term bank deposit products, local government liquidity funds, money market mutual funds offered by banks or other financial institutions, and short-term treasuries and agencies that may be laddered out to ensure adequate liquidity.
The core segment may be invested in the same types of instruments, but with longer maturities that may enhance return expectations. Typically, longer maturities suggest greater return but also greater volatility. Funds that are not needed for liquidity, such as those in the core segment, may be better able to withstand the volatility that may occur over time. Appropriate investments for this segment include: longer-term bank deposit products, treasuries, agencies, funds with intermediate-term horizons, and other instruments allowed by statute. Depending on state statute, investors may wish to include corporate bonds. (Corporate bonds add an element of credit risk and market risk over short-term government securities.) Increasing maturity and including credit are two common strategies for enhancing return. In all cases, investors of public sector funds must ensure tight parameters for this segment.
The simple act of segmenting or creating different “buckets” within your overall investment portfolio can be a useful way to ensure that all your objectives are met: appropriate liquidity for obligations and appropriate risk-adjusted return, while ensuring the safety of your overall portfolio.
The GFOA Executive Board adopted two best practices pertaining to investing at its September 20, 2019 meeting, Collateralizing Public Deposits and Using Cash Flow Forecasts for Treasury and Operations Liquidity.Read more