TIMPG meeting stresses the need for a disciplined investment process as well as the importance of putting excess cash to work.
Members of the The NeuGroup’s Treasury Investment Managers’ Peer Group marked their 20th annual meeting, sponsored by Neuberger Berman, by focusing on the investment portfolio, adding yield and managing interest-rate risk. Also discussed was the changing money market fund landscape. Further highlights from the meeting included:
1) Deep dive into fixed-income relative value. Neuberger Berman walked members through a deep dive of the fixed-income markets. The firm outlined its disciplined investment process, which it believes is necessary to make market calls repeatable. Neuberger Berman is advising clients to be short duration and is constructive, although cautious, on adding credit. The biggest challenge for members is where to allocate assets.
2) Asset allocation and portfolio positioning. All the members reported that their investment portfolios are short or neutral in duration to their respective benchmark. More than half of members have not made changes to the investment portfolio, as many have already structured their portfolio for higher rates and are patiently waiting. For those making changes, the theme with members is continuing to add credit and/or new asset classes to add yield to the portfolio. The offshore portfolios continue to see the most action.
3) Portfolio optimization. The combination of sectors is as important to the investment portfolio as individual security selection. Members use a variety of systems for optimization scenarios, including, our favorite system, Excel. Andy Tank outlined how Neuberger Berman uses long-term historical data representing a full market cycle in their optimization scenarios. They look to maximize efficiency or return per unit of risk. Built into their optimization models is a probability scoring model, and equally important in their analysis is the confidence level around their return expectations.
4) Risk management and reporting. Most members include duration in the risk analysis. Also, metrics involving capital or earnings were popular. These metrics were credit capital or earnings at risk. Members also use historical volatility to measure risk.
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Looking Under the Fixed Income Hood
Members discussed interest rates and the broader implications of quantitative easing. Also reviewed was a disciplined investment process for predicting the direction of global interest rates. Relative value of specific asset classes was also discussed.
KEY TAKEAWAYS
1) Three component investment approaches have led Neuberger Berman to suggest that rates are undervalued and that US rate increases are to be expected in mid-2015. The three components are:
- Country analysis—economic outlook and business cycle perspectives
- Government bond outlook—review monetary policy outlook and market expectations
- Inflation-linked bonds—inflation decomposition and break-even inflation
forecasts.
2) No one wants zero rates in perpetuity. Momentum is building. US GDP and net worth have recovered strongly post-crisis, while jobs and production are gaining steam. However, house prices remain well below peak levels. Something will have to change and eventually fed fund rates are going to rise. Everything follows from where fed fund rates start.
3) Credit looks good. Although valuations are at a level where Brad Tank from Neuberger Berman remarked, “The market could be a bit over its skis,” when looking at credit, he feels it is equally important to have conviction in your total return expectations. Built into their models are factors that measure certainty. A security could have a higher return, but that is beaten out by a security with a lower return and higher conviction.
4) Short forward rates can tease out expectations for fed fund rates. Neuberger Berman, explained how they look at short forward rates and tease out market expectations for fed fund rates. “Currently the market is pricing a really bad economy, and we just do not agree,” one Neuberger Berman team member said. He believes that interest rates have to increase to move to fair value. As noted in the Exhibit 1 chart, the yellow line represents market expectations and the red line represents the “fair value” curve, where Neuberger Berman believes the rates will go.
OUTLOOK
Several factors influence expectations on rates. Neuberger Berman made a case for an improving global economy and thus rates heading higher. Members agree when it comes to the credit market; several members in addition to Neuberger Berman are favorable on this sector. When members were asked what sectors concern them most, US Agency issues were mentioned, along with money market funds; this was a first. Everyone likes credit, they just do not like rates.
Changing Money Market Fund Landscape.
After four years of debate, the SEC has finally approved a series of reforms to money market mutual funds. Despite the fact that changes will not be implemented until two years down the road, members are starting to prepare. We will discuss the SEC changes and how these changes will impact the investment program.
Members of the TIMPG got an overview of the situation and learned that changes do not impact investments allowed directly. The found that the world has not changed too much, yet. “Regulations do not alter the investments within the portfolio,” noted one member whose company is both a user of money market funds and a large issuer of commercial paper.
Members still wondered though if the floating NAV would alter investment styles in general and indicated that are less willing to take risks.
Asset Allocation and the Portfolio
Given where rates are today, an increase in rates is inevitable. How long are we going to wait? Have members given up on the defensive posturing or have they continued to structure the portfolio more defensively in anticipation of rising rates? What are members’ thoughts on the spread sectors? This session included a discussion on how members are structuring the portfolio and preparing for changes in interest rates.
KEY TAKEAWAYS
1) And we wait. “No changes” was again the most popular response to the members’ survey question about changes made to the portfolio. However, the reason is not that everyone isn’t preparing for something; we are just already there. Currently all of the members that responded to the survey are either neutral or short their duration targets. Members are short wherever they can be.
2) View on the market is not the only driver of portfolio changes. Business operations have a significant influence, as well as the view on interest rates and credit.
3) The offshore piles continue to grow. The biggest challenge, noted one member, has been, “Where are we allocating to this year? We are going to have lots of cash come in from offshore.” Several members echoed this sentiment. Members struggle with deployment knowing the offshore pool is the more stable pool. Some members are keeping excess liquidity for potential business purposes.
4) Neuberger offered some suggestions for asset allocation. First, consider the municipal market. This market has suffered, as it is still predominantly retailinvestor owned, and retail investors misconstrue what the Fed says. “Detroit was a slow-moving train wreck,” explained Neuberger Berman. “Their financial woes pushed muni ratios on both ends of the yield curve to attractive.” On the flip side, Neuberger Berman noted that it is fairly negative on the Agency MBS market. Here spreads have been determined by government entities for the past twenty years and he sees potential downside.
OUTLOOK
Members are finally starting to see higher rates out on the horizon. However, this does not mean large-scale rejiggering; we are already there. Members are continuing to seek yield through investment in many of the spread sectors and are focusing on taking more risks in the offshore accounts.
Optimizing the Portfolio
The combination of sectors is as important to the investment portfolio as individual security selection. The discussion centered on the rationale for adding new assets classes and tools used for asset allocation.
KEY TAKEAWAYS
- Excel remains king. Excel is the most popular “system” used by members for portfolio optimization, as it is used by 78 percent of respondents. As noted in Exhibit 3 below, a majority of members use an internally driven asset allocation methodology.
- Market mispricing provides opportunities to add value for those with unique insights and conviction. “Process has to be rigorous and repeatable to access how comfortable you are with what you think you know,” explained one Neuberger Berman team member.
- Neuberger prefers long-term historical data for their analysis. Therefore its analysis included a full market cycle. The firm understands that this could mean using old data to predict new, but it’s a risk they are willing to take. When they optimize they maximize Sharpe ratio or maximize tracking error. Their goal is to maximize efficiency or return per unit of risk.
- CVAR is a great metric for measuring risk/return profile. This metric is a good measure of tail risk. Andy used the example of, if you do not want downside risk to be more than 2.5 percent, run the optimization. See what the outcome will be before constraining. If you can’t imagine living through the outcome, reassess. CVAR is always going to be the toughest stress.
OUTLOOK
Having a good return expectation is not enough, you have to be confident in your expectations. Developing a framework that works for your particular risk/return profile is critical. Most members use an internal asset allocation and build this allocation into their investment policy.
Risk Management and Reporting
Market volatility and stress have increased the importance of measuring risk. We examined the metrics used to measure risk, the management of risk reporting and how risk metrics are incorporated into the investment decision.
KEY TAKEAWAYS
1) There are as many management reports as members in the group. Each company and investment board has particular reports they want to view. The reporting cycle also varied ranging from weekly to quarterly.
2) Giving structure to a complex investment portfolio. One member presented to the group his company’s portfolio risk, compliance, and reporting framework. His group’s role is to manage excess capital that comes up to the parent company level, and a dual treasury mandate to be consultant to business groups. The company has decentralized treasury personnel. These groups have their own working capital to invest; the presenter’s group is a resource to them to help manage these assets.
3) Tiered investment portfolio. To manage their risk, the company has tiered the investment portfolio to allow for immediate operating needs in a liquidity tier and take on more risk with assets they do not require for immediate business functioning.
- Tier 1: Includes T-bills, bank deposits, and commercial paper. It is their goal to push as much as they can to riskier assets beyond what is required for operating purposes or stress events. This segment requires less reporting and risk measurement as it contains less risky assets.
- Tier 2: Enhanced cash. The target duration for this segment is 12-18 months. These portfolios are managed in-house and externally. In this segment more risk management at parent level is performed. A risk budget is determined by the amount of market and credit risk that the company can take. An MCAR (market capital at risk) calculation is provided to management. This number represents the dollar amount of loss in a liquidation scenario based on historical price volatility. Credit risk is evaluated by the dollars of simulated losses from the rating agency default tables. Not only is less liquidity required for this segment but also the investments have more of a long-term focus.
- Tier 3—Hedge fund portfolio. The target volatility is 6 percent and return is Libor +5-6 percent. The management of this tier is partially outsourced to the pension group and others in the Treasury group fully dedicated to hedge fund relationships.
OUTLOOK
When members think of risk, they think of metrics and reporting. An additional way to manage risk is to separate the portfolio into buckets. Each bucket is aligned with an operating or capital need. Each tier or bucket can have a unique investment policy and set of risk metrics. Measuring risk is also easier and more efficient; this methodology also allows you to spend more time in the areas that contain more risk. Another benefit is that when you outsource the management, a specific investment policy can be given to the external managers for that particular segment. When considering risk, think systems and segments.
CONCLUSION & NEXT STEPS
Neuberger Berman began the meeting by outlining its very process-oriented approach to investment management. “Process makes it repeatable,” said one member of the Neuberger Berman team, a sentiment echoed repeatedly throughout the conference. The firm also noted that they work in a very collaborative fashion. Both of these themes seemed to resonate throughout the sessions. During two days of active discussions the need for a disciplined investment process was stressed. During our allocation discussions, where we also worked in a very collaborative fashion, members shared their struggles with putting excess cash to work. The Neuberger team also shared ideas on how to add yield to the investment portfolio and their thoughts on where not to invest assets. Members shared ideas on how they measure risk and how risk is reported to management. We focused on process, how tomake actions repeatable, and most importantly having conviction in your return expectation or any investment decision.