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Choosing and Using Benchmarks
By Linda Patterson
New law changes in Texas, and around the country, focus on new reporting requirements to governing boards and commissions. That is because the legislators recognized that in many trouble-ridden portfolios today those governing bodies had been neglecting their oversight responsibilities. The long bull market, which promised continuing profits and opportunities, and the low interest rates, which reduced earnings substantially, forced many investors into high risk situations.

Problem portfolios typically are loaded with high-yield - or promised high-yield - securities. Typically, these problems are the result of two actions by the investor. (1) The investor was invariably stretching for yield for additional earnings or because the market made it look so easy to get yield without risk. However, the market requires risk before reward. The stretch for yield placed more risk than was acceptable in the portfolio and when the market changed the risk remained and the reward had vanished. (2) Secondly, the investor lost track of the level of risk in the portfolio and created excessive exposure to one type of security or sector. Portfolios were barbelled (long and short securities without a ladder to mirror liabilities) or relied solely on one type of security (usually mortgage-backed securities). Normal diversification strategy was traded for risk. The governing bodies had the ability to see these problems develop but had ignored a simple technique that would have identified the developing problem before the portfolios turned in losses.

Benchmarking portfolios and straightforward regular reporting, including those benchmarks, can be your reality check against the tendency to reach excessively for yield. It can also alert you to excessive exposure by security type or market sector. A benchmark must be set with care and thought and then used regularly in reporting.

In a public funds portfolio, the first responsibility of the investor is to know and understand the goals and objectives of the portfolio. Our primary objectives are liquidity and safety. Therefore, portfolios should be short to prepare for liquidity needs and of the highest quality to fulfill our public fiduciary responsibility for safety. Most public entities' portfolios represent operations during a single fiscal year. Therefore, the average weighted maturity (WAM) of the portfolio should be approximately six months or less.

A review of the cash flows during those twelve months will allow you to reasonably set your optimal weighted average maturity. For example, if you have a higher percentage of capital funds which will not be spent for two years, then, the WAM may be longer (180 days). But, if you have less or no longer funds and all the funds will be spent in one year, then, the WAM may be shortened to 90 or 120 days. This establishment of a realistic WAM for your portfolio is paramount. It is this WAM that will help you choose your benchmark.

Since safety is our primary focus, the benchmark for almost every public funds portfolio should be the US Treasury yield curve. As a busy public finance professional, with many hats to wear, you are not paid to significantly outperform the Treasury market. (That is the job of professional money managers who can concentrate on the market and have the technology to follow that market. A public manager is only paid to match or "beat" the Treasury curve by 20-40 bp.)

Once you have set your WAM, you have your benchmark. If your WAM is 180 days, your benchmark is the six month Treasury Bill. By using this benchmark in your regular reporting it can alert you to any dangerous trend towards stretching for yield. For example, when we were in a three percent interest rate environment for a three month WAM portfolio (the benchmark) a portfolio yielding six percent would automatically be suspect. Such a gap over your benchmark screams "risk"! Conversely, if you are significantly below your benchmark, you know the portfolio has market value losses that might need to be addressed, or you might need a change in strategy. The WAM of the portfolio, the yield on the portfolio and the benchmark for that same period should be included on each monthly report you produce. This will give you a realistic picture of how you should be performing versus your specific performance.

The comparable maturity Treasury Bills are the most natural benchmark for public portfolios. You need to compare the average yield on the Bills against your portfolio for the same period. In order to help you do this comparison, Patterson & Associates will be posting the average yield for the three-month, six-month and one-year Treasury Bills on LOGIC's bulletin board by the first business day of each new month. Choose your WAM and compare it to the appropriate benchmark each month to spot trends and keep any portfolio you maintain outside LOGIC safe and secure.

This article is reprinted with the permission of:
Patterson and Associates
301 Congress Avenue, Suite 570
Austin, Texas 78701
(512) 320-5042 or 1-800-817-2442