Three Types of Public Entity Investment Partnerships
Governments know they have a fiduciary responsibility to manage public funds in a sound and responsible manner. Each entity’s investment partnerships should support this good stewardship as well.
The Government Finance Officers Association recommends that state and local governments “exercise caution and prudence in their selection of investment advisers” and that “the implementation of a safe and effective investment program must be carefully coordinated with the adviser.”
Public entities may not be aware of the various solutions available for their investment program, which could result in a misalignment of the portfolio with their specific financial needs. This document attempts to demystify the investment partnership options available to public entities.
Different Types of Investment Partners
As part of a robust public entity investment program, it is important to perform due diligence on investment partners as well as an annual review. For any institution, there are myriad ways to access these vital investment services. Let’s take a look at the three most common solutions: investment advisers, brokers and banks.
A registered investment adviser is overseen by the U.S. Securities and Exchange Commission (SEC) and has a fiduciary duty to their clients. Investment advisers typically don’t charge fees based on transactions but rather a fee based on the total assets under management. This type of service also tends to provide discretionary management, in which the investment adviser makes the investment decisions and executes trades for the client, although these decisions are made within guidelines that have been outlined by the public entity. Investment advisers typically provide guidance regarding portfolio structure and other investment-related services.
An alternative to an adviser is a securities brokerage firm. Brokerage firms are regulated by the Financial Industry Regulatory Authority (FINRA), and may not have a fiduciary responsibility. Agreements between brokerage firms and public entities are usually non-discretionary, meaning the broker must obtain approval before executing any trade. These relationships are more transactional than a holistic advisory service, whereby brokers identify a bond that may be of interest and contact the client for each purchase. They receive compensation through a transaction-based fee or a premium or commission on trades, which may not always be fully apparent. Additionally, with broker-dealers, government bodies may receive reporting, but typically receive a limited scope of additional services.
It’s important for public entities to understand the scope of services available.
Local banks are among the most common investment partners for smaller government organizations. Typically government entities end up working on their investment portfolio with the bank’s treasury management services. These arrangements usually leave the public entity directing the investment parameters and working with bank advisers to identify savings accounts, CDs or other investment vehicles that fit those needs. Banks often provide little investment guidance or portfolio diversification since many of the investments they offer reside within the bank itself.
While these various types of investment arrangements all have pros and cons, it’s important for public entities to understand the scope of services available and what they would like. A more robust set of investment services requires a more comprehensive partnership.
Considerations When Choosing an Investment Partner
Investment programs for public entities should be aligned strategically with their cash flow needs and what the entity wants to accomplish from a public policy perspective. They also need to be diversified and cognizant of market activity, and have ongoing management and monitoring of investment activity. These key considerations can help your public entity evaluate which investment partner is the best fit.
Determine what type of relationship your organization needs with your investment adviser. Do you want an investment manager that is going to meet with you regularly, go over your portfolio and evaluate the options with you? Or do you want someone who calls you to tell you they have a bond for you to buy? These are fundamentally different relationships.
Public entities need to establish risk and return objectives. Public entities handle this in substantially different ways depending on their needs, but generally this step includes establishing a risk profile that’s consistent with their risk tolerance. Government financial managers need to ask how important it is for the entity to have robust risk controls — and whether that can be accomplished internally. How will you be sure you’re in compliance with state code and your internal investment policies? If you don’t have someone reporting this to you, how are you doing this today? Will your portfolio provide cash flows as you need them or will you be forced to sell at an inopportune time?
How will you limit your exposure to risk factors such as industry, issuers, maturities and credit quality? What is your exposure to interest rate risk (fluctuations in interest rates), reinvestment risk, credit risk, liquidity risk, etc.? Do you have a well-balanced risk profile? An investment partner should be able to assist in this step through the investment process.
Is it important to you to be sure you are receiving best execution (best yield or pricing) on the investments you purchase? Is your investment partner able to use multiple trading counterparties to help ensure you get appropriate execution or do they just provide one price and yield? Does the investment partner have competitive trade executions? Investors are typically able to get better pricing, yields and execution if they are able to compare among multiple service providers.
All investment partners charge fees — how transparently can you view them and what do you want to drive your fees? Do you want to incentivize your partner to bring you additional trades or to preserve principal and grow the assets? Does your organization know what you’re paying in fees for the various portions of your portfolio, and how that compares with what you could get with a different service provider? Often, fees may be more than you think and can significantly impact what you are receiving in both total return and income. Fees vary widely by investment partner and warrant careful consideration.
Are you getting additional resources from your investment team or are you merely getting stocks and bonds? Ideally, an investment partner should be helping you to construct a portfolio that aligns with your cash flow, quality, and income needs as closely as possible. How are you benchmarking performance? How do you know if your portfolio is meeting your objectives?
Additional services could cover a host of factors beyond portfolio construction and benchmarking. These include asset allocation, ongoing economic and market education, portfolio stress testing, compliance verification, meetings and communication, custodial liaison services, and cost controls. As an organization, do you want these services? Do you want the value add of a team backing your investment portfolio?
Establishing the Relationship
Onboarding with your investment partner should be smooth and should set the tone for the relationship moving forward.
It should be clear what expectations the adviser has for you and what you expect from the investment partner — and how you and the adviser will move forward together throughout the investment process. Who does what, what’s the timeline and how much of it is on you to execute should all be clearly spelled out through onboarding. This is a simple process that can quickly become complicated without clarity and transparency from an investment partner. An investment partner should lead the onboarding process while making you aware of all the steps along the way.
Annual Review & Regular Due Diligence
Public bodies are required to maintain an investment program, which includes regular review of investment policies and controls. The GFOA recommends that the process involves a careful review and does not become an end-of-the-year rubber stamp.
The same careful review should be performed on all investment options and partners as well. The markets change quickly, as do an entity’s needs. Verifying that investment partners have met your performance standards, remain creditworthy and have added value over the relationship is critical.
While this may all sound like a lot of work for many public entities, selecting the right investment partner for you will save you time in the long term, can help you meet your objectives, and may also save you money.
Contact us today for more information or help in evaluating your investment partnership needs.