Risk Rides the Periphery of Investments, Portfolio Optimization

 Treasury investment managers are revising investment policies, expanding asset classes, reviewing asset managers, and implementing or reviewing treasury workstations — while risk is on the rise. 

Risk is on the rise. The most common changes in the last six months have been increasing the domestic portfolio’s credit risk and expanding allowable asset classes in the offshore accounts. TIMPG members clearly have a bias toward adding more risk versus taking risk off the table. As a result of these changes, projects for 2015 include revising investment policies and reviewing asset managers. Key highlights from their meeting include:

1) Risk Management in a New Cash Paradigm: Regulations surrounding prime money market funds will encourage fund managers to invest much shorter. As a result very short, liquid fixed-income paper will be in high demand. Many wonder if demand will outstrip supply.

2) Tracking the Portfolio Accurately and Getting the Right Mix: There are good reasons why Excel is used by most members to supplement their portfolio optimization software. Another struggle is finding the right amount of cash to hold, and what to put in a longer account.

3) Benchmarking the Investment Program: With so many restrictions, a simple off-the-shelf benchmark will not work.

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Risk Management in the New Cash Paradigm

How do you measure liquidity risk, which has become the biggest investment risk, and how do you manage what you cannot measure? TIMPG members discussed how liquidity will be affected by recent regulations and how to start to evaluate this risk. Discussion also included a review of stress triggers to focus on as interest rates and credit volatility increases.

Key Takeaways

1) Regulation is redefining risk. Brandon Swensen, co-head of US Fixed Income at RBC Global Asset Management set the risk stage with a quote from Warren Buffett: “Only when the tide goes out do you discover who’s been swimming naked.” Brandon related this to the importance of understanding what you own and knowing what your liquidity needs are. The typical investment risk hierarchy included interest-rate risk (rising rates and volatility) and credit risk (default, downgrade, and fraud). Members should now be concerned with liquidity risk, or market risk, and price realization. “This is the risk that there is a bid when you need a bid and the bid is where it was marked last night,” explained Mr. Swensen.

2) Fixed-income markets have rewarded risk-taking. Looking at the past ten years’ worth of data, investors have gotten what they reached for, as the risk-reward graph below demonstrates a very linear slope and an efficient market. Knowing your cash-flow needs and being able to take on as much risk as possible has paid off with incremental yield.

3) Time heals short-term pain. Rising rates should not be a major concern in this environment. As rates go up, the new higher yields can make up what is lost in price return. As Mr. Swensen explained, for a short-duration core strategy (1.7 years’ duration), and a rate shock of 100 bp, the expected total return is only slightly negative at -0.10 percent; with rate shocks between 25-75 bp the expected total return moves positive.

4) Breaking the buck in a money market fund would take a significant shock. Even during the financial crisis money market funds did not get here. The 2010 reforms went a long way toward making money market funds safer, and as a result are well- structured to absorb volatility. To break the buck, the market would have to experience both significant interest-rate and spread movement.

5) Fees and gates are the bigger concern. As a result of this regulation, money market funds will need to hold liquidity buffers significantly above the threshold for implementation of the fees and gates. The last thing a fund manager will want to do is have to call the board and possibly implement a fee or gate. Prime funds will have to hold assets (repo, government securities) of more than 30 percent to bring down volatility. Maintaining this liquidity buffer will be a driving force in managing a prime fund.

6) The future of prime funds does not look rosy. For prime money market funds to have an advantage over government funds, the yield advantage would have to be meaningful — currently it is not. Investors are starting to do the math and discovering that staying in the prime funds is not worth the yield differential to government funds and the hassle of a floating net asset value (NAV). Prime money fund managers are also doing the math and several fund complexes are eliminating prime funds or expanding alternatives.

7) More bad news around liquidity. Regulators are driving the cost of liquidity onto investors. As a result of the Dodd-Frank and Volcker rules, brokers are carrying lower inventories and as a consequence wider bid/ask spreads. Also thinner volumes will mean higher volatility. The eventual cost of the liquidity drain will be higher transaction costs, more volatility, higher liquidity buffers and more demand for liquid bonds.

8) Risk program needs constant evaluation. One practitioner noted that the focus at his company is on trapped cash; here they have to take risk, so the focus is on ensuring they are getting paid for the risk they are taking. He noted that the company also evaluates and makes sure it is looking at the right metrics. “It is important to have confidence in the risk management as you cannot avoid risk,” he explained.

Outlook

Understand your cash flow. Liquidity will get more expensive to keep and as a result, members are going to have to think about their needs harder than they have in the past. Although it is still too early to understand what the future of short-term cash investing will bring, one thing is for sure: liquidity risk is becoming an increasing risk concern.

Portfolio Optimization: How Do We Get the Right Mix?

This session broke down each component of the corporate cash portfolio. Should all investments be in one portfolio or does it make sense to tier the portfolios? What works best for members? We also discussed the rationale for adding new asset classes and what systems were used in deciding how to get there.

Key Takeaways

1) Choosing the right data for creating an efficient frontier can be difficult. One group member described how a former employer was always trying to figure out how much of which instruments to keep. First, the practitioner’s team tried using total return in the calculations, but this did not work; then, they moved to yield as an approximation for standard deviation. Once they received daily yields and had standard deviation, the calculation sort of made sense when graphed. After a good amount of work, the solver program selected a portfolio of 100 percent time deposits so they had to constrain it to the guidelines. A good amount of time and effort was spent for no significant results.

2) Optimization works well for equity, but not for fixed income. One member company uses Bloomberg PORT, which can perform optimization and identify trades to reduce VaR. “This is one measure, but it doesn’t give anything surprising,” noted the company’s investment manager. Another company uses BlackRock Solutions to identify exposures but “reinvestment risk is hard to get, and we have to make our own assumptions,” explained the member. Several members use Clearwater for portfolio attribution, although it was noted that Clearwater isn’t quite up to the level of sophistication of the BlackRock system.

3) Let the managers decide. Several members have given their managers broader-based benchmarks with sector limits and let the external managers decide on allocation. One practitioner explained that her company has two managers with expertise in ABS and MBS, within limits; the two managers are given latitude to decide on the allocation.

Outlook

Unfortunately, portfolio optimization for members becomes more of a back-of-the-envelope exercise than they would like. The volatility and variation of return is not significant enough for members to create an efficient frontier and maximize risk/return in a meaningful fashion. Limited success has be found through systems such as Bloomberg’s PORT and BlackRock solutions to at least create metrics that can be used for guidance.

Benchmarking the Investment Program

Members reviewed a comprehensive list of factors that can be used toward evaluating the investment program. The end product of this session is a TIMPG-derived model that members can use in evaluating their asset managers and investment results.

Key Takeaways

1) Peer benchmarks are helpful in convincing management to implement change. Whenever trying to convince management to make a change, the first question asked is, what does everyone else do?

2) Glad to be so in line. One member company relies on income from portfolio for earnings. One key metric for the company is yield. The company’s investment manager explained that the company is generating about two percent annually, which he was happy to report is very similar to the group. The company also looks at duration for a measure of risk. Its portfolio duration was also in line with the group median of two years, and its three headcount devoted to the investment portfolio is also the TIMPG group median. As the company is looking to expand its portfolio beyond US Treasuries, it found it is very helpful to show management the asset classes other TIMPG members use in their investment portfolios.

3) Comparing manager performance is a popular measurement tool. Members have struggled with investment benchmarks and how to use them to measure performance. One member company has multiple managers for each mandate and compares managers within each asset class. The company does let managers know how they rank against one another and gives them a long runway and plenty of time to prove themselves.

4) Qualitative factors are important also. One metric that one of the member companies considers, but that is more difficult to measure, is how the manager makes a call in a crisis. One of the company’s investment managers foresaw trouble and got out. Others didn’t think it would be a big deal and was still a good value, so they stayed in. But can they make the call? This counts when deciding where to add money. Additional factors include level of service and ad hoc analysis. The company has found that some managers are better than others in this area.

5) Demonstrating income generated is an important component of the evaluation. One practitioner shows not only total return but also the income they have earned (extra above the benchmark). Another practitioner told members that his company shows total return and coupon to management. Doing this lays the groundwork for future negatives, if they happen. Another breaks down price and income return, and shows management the dollars behind the numbers and shows both unrealized and realized gains and losses. Still another member company looks at money market accounts to show where they added value.

Outlook

Nothing beats showing your managers how you rank versus your corporate peers. Peer data can be used to increase risk, if others are taking more, or to say we are in the right place, if you seem to line up with them. One member company’s project gave others some great benchmarking data to review. Benchmarks for shorter-duration portfolios can be tricky. Lining up managers against one another is one of the more popular ways to measure investment performance.