10 Key Steps For Managing School District Investments: | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | Glossary |
5. Learn how to manage risk.
The old adage about the dangers of putting all of your eggs in one basket is of particular value in investments. All investments involve risk. There is a risk of losing money, but there is also a risk of not earning all that you could. A balance must be established between the high rate of return with riskier investments and the risk of earning less than is possible. This balance is basically seeking to achieve a market rate of return, a general term referring to the approximate interest rate that could be earned in a specific maturity range at any given point in time. Districts should work to achieve a market rate of return, and if the actual return exceeds the market rate of return, then be sure everyone understands the risks involved. Some of those risks are discussed below.
Diversification or investing in different types of instruments with different maturity dates spreads the maturity, liquidity, credit and market risk. Various investments react differently during changes in rates or different market conditions.
The primary risks for public entities are:
Credit Risk: The risk that the issuer of a security will not be able to pay interest or principal on a timely basis. Credit risk is minimized by buying high credit quality securities, as authorized by state law, and by making sure that all investments are collateralized, where collateral such as securities, evidence of deposits or other property, is pledged to a lender until a loan is repaid. If the borrower defaults, the lender has the legal right to seize the collateral and sell it to pay off the loan.
Liquidity Risk: The risk that the investment cannot be sold and that cash cannot be obtained when needed. There is a risk that school districts that are investing operating money will need the money before the investments maturity date and will not have access to the money or will have to pay a penalty to get it.
Collateral Risk: The risk there will be insufficient collateral to fully compensate the district if the institution fails and cannot convert the investment to cash as agreed. There is also a risk that the ownership of the collateral is not perfected and the custody of the collateral may revert to an independent institution.
To minimize risk, a district should require a minimum of 102 percent collateral on the market value of the security and the expected interest earnings.
Market Risk: The risk that the price of the security could change and create an unrealized or realized loss. For example, if an investor purchases a security for $100, but the price of that security falls to $80, the investor would have suffered a $20 loss. The loss is realized if the investor sells the security for $80, however the loss is considered unrealized if the investor continues to hold the security in hopes that the price will come back up to the original price or higher.
Volatility Risk: The risk that a security or commodity will rise or fall sharply in price within a short-term period.
Opportunity Cost Risk: Opportunity cost is the difference between a current investment return and an alternative investment offering a higher return. For example, an investor might buy a safer U.S. Treasury security yielding 6.00 percent instead of commercial paper yielding 6.75 percent. The 0.75 percent difference in yield between these two options is referred to as the opportunity cost.
Risk, or the amount of risk a board is willing to take, directly affects what investments will be authorized and the potential for return on investments.
As mentioned earlier, diversification is the spreading of different types of risk over a large number of securities to reduce financial risk or the process of using different securities and maturities in a portfolio to reduce market and credit risk. The goal of diversification is to balance or spread risk and to minimize fluctuations in both the portfolio value and income. It is essential to understand investment risks and cash flow needs before one can properly balance those risks through diversification.
To create a diversified portfolio, investment officers must understand some basic principals and then use their judgment to apply those principals to their situation. To avoid keeping all of a districts eggs in one basket is a good rule of thumb, but just throwing eggs into different baskets without some thought can lead to disaster. Diversification requires thoughtful consideration.
Each school district has a portfolio that, while similar to other school districts in some ways, will be unique in others. For example, a diversified portfolio for a school district with a $100 million portfolio will look quite different from a diversified portfolio of $5 million. Two school districts with similar sized portfolios, but varying cash flows will look quite different as well, however they may both be sufficiently diverse.
There are basically three major categories of diversification: diversification by maturity, issuer and type.
Diversification by Maturity
When a portfolio is diversified by maturity, the investments mature at different times. There is no hard and fast rule to follow in diversifying by maturity, however the principle is that investments mature at different times, unless your cash flows absolutely require investments to mature at the same time.
A cash flow forecast is the most important tool one can use to determine where to place the maturity of investments in the portfolio. But, dont extend maturities just for the sake of "diversification"; it is essential that investments are not maturing after cash flow needs occur.
One reason for having different maturities is that as securities mature and are reinvested, all investments will not be reinvested at the same time. Because of the way ad valorem taxes are collected in Texas, we already have a built in system that requires us to break this rule by investing the bulk of our money during a short period of time. If markets are down (up) at the time those funds were invested, the bulk of the portfolio will be invested in a(n) down (up) market. But, by investing in securities with different maturity dates, the risk will be spread over the rest of the year.
A typical example in Texas of a portfolio that is not diversified by maturity is a school district with all its funds in overnight investments. If cash needs are immediate, this may be the ideal strategy. However, an overnight investment fluctuates daily with the market. If ones entire portfolio is in such investments and rates drop dramatically (or increase dramatically) then the entire portfolio will follow the direction of that change. Going back to the basic concept of diversification, a district may want to minimize potential income fluctuations by having some funds in fixed rate accounts that mature at later dates to stabilize earnings. You may not make as much in the short run if interest rates rise, but you have hedged your bets if interest rates drop.
Diversification by Issuer
When a district has diversified by issuer it has investments from various issuers making up its portfolio. An issuer is the entity that originates the debt and guarantees the final payment. Examples of issuers are the U.S. Treasury; banks; federal agencies such as Federal National Mortgage Association; or funds or pools, such as Lone Star, Logic, and TexPool.
The concept behind issuer diversification is to minimize credit risk, the risk that an issuer will default. If an issuer defaulted and all of a school districts portfolio was with that issuer, this would be a major catastrophe. Investments authorized under the Public Funds Investment Act are almost entirely high credit quality instruments, so the risk of default is generally low. However, it is still a good idea to diversify where possible, by issuer.
Diversification by Type
When a portfolio is diversified by type, this means it has a balance of various structures or types of investments. Some examples of investment types are: Local Government Investment Pools, Money Market Mutual Funds, U.S. Treasury Bills, U.S. Treasury Notes, Agency Discount Notes, Agency Coupon Notes, CDs and Commercial Paper.
To be diversified by type, not all investment types must be included in each portfolio. In fact, for smaller portfolios it would not be prudent to include all of them.
The idea behind investment diversification by type is to hedge your bets. Put some investments in investment categories that prosper during rising interest rates, while keeping some in investments that prosper when interest rates drop. The overall gain on investments is reduced, however the diversification of the portfolio has protected the districts assets.
For example, when interest rates are rising, investments in liquid assets, such as money market mutual funds and pools will generally perform better than others because as the market rates go up, the daily rate paid on these investments quickly follows. However, investments with longer maturities will lose value in the same market. Conversely, when interest rates are dropping, investments with longer maturities will hold their value. By having investments in both areas, you minimize the overall gain or loss in the portfolio.
Following the rules of diversification will not ensure a school district does not experience a loss. However, it does minimize the risk of fluctuating values and income. Diversification requires judgment and thought and should be a major consideration when purchasing investments.
The idea is to spread risk. Investing in two or three different securities, for example, does not necessarily equate to diversification. Everyone must look at the reports provided, read information statements and prospectuses and ask these questions:
- What risks are involved in this security?
- Will we have access to the money when we need it?
- How is this pool or fund different from other pools or funds?
- What kind of economic conditions would cause this investment to increase or decrease in value?
- Who can we turn to for sound advice?
Below is a list of additional resources you may find helpful. Information in the documents and URLs listed below are not endorsed by this agency, but only provided as resource material. For more information on these resources, consult the bibliography.
Types of Investments
(Treasury Operations, Comptroller of Public Accounts)
The various types of allowed and disallowed investments, the advantages and disadvantages of different types of allowed investments and the risks associated with each.
Managing Risk in Investing School District Funds
(University of North Texas and Public Financial Management, Inc.)
How school district policies, strategies and procedures can help manage risk when investing funds.
Investment Strategies for Smaller Entities
(Patterson and Associates)
Investment strategies for smaller entities such as a school district with limited funds to invest. Different types of investments are described and discussed. Portfolio strategies are also outlined.
The Ghost of Orange County
(First Southwest Asset Management)
The crisis in Orange County, a governmental entity that lost money through risky investments.
|IMPORTANT NOTICE: The information in this document is presented solely as technical assistance and as a resource available to school districts. The information does not serve as a substitute for legal advice nor replace the independent judgement of a district's governing body concerning its investments. A district should consult its attorney or other appropriate counsel such as its investment adviser to resolve questions about its investment transactions.|