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CHAPTER 2: INVESTMENT MANAGEMENT

2.1. INTRODUCTION

The purpose of this chapter is to set forth general guidelines for the investment practices of First 5 commissions. Public fund investing includes short-term investments to meet daily cash flow requirements and long-term investments to meet future goals. These guidelines are based on current best practices in public investing and offer the flexibility necessary to accommodate different types and sizes of commissions.

In most cases, commissions will not be conducting day-to-day investment management, but will delegate this duty to investment professionals in the public or private sector. Most commissions currently delegate this duty to their county treasurer. However, in order to provide proper stewardship of public funds, it is important that commissions are familiar with fundamental investment concepts, and to the extent allowed by their County Treasurer , play an active role in setting the goals and policies of their investment program, and monitor and oversee professional portfolio managers.

The content of this chapter is primarily based on GFOA Recommended Practices and publications as well as the Local Agency Investment Guidelines: Update for 2007 produced by the California Debt and Investment Advisory Commission (CDIAC).

Key components of the California Government Code that affect investment management are listed and described at the end of the Agency Investment Guidelines document. Relevant code includes sections 16429.1 – 16429.4, 16481.2, 27000 – 27013, 27130 – 27137, 53600 – 53609, and 53630 - 53686. The full code is available online.

2.1.1. Types of Investment Risk

All investments contain an element of risk. Below are the major types of investment risk.

Credit (default) risk. Credit or default risk is the risk that some or all of the principal amount of the investment will not be available due to default by the issuer, securities broker or dealer, or financial institution. Default risk can be controlled by carefully screening and monitoring the credit quality of issuers, brokers, dealers, and financial institutions; by limiting investments to those of the highest credit quality; and by insisting on holding collateral against certain investments. National credit rating agencies can provide ratings on securities such as commercial paper and bankers' acceptances. Bank rating agencies can provide ratings on financial institutions and savings and loan institutions. For more information, visit http://www.fdic.gov/bank/individual/bank/.

Liquidity risk. Liquidity risk involves the ability to sell an investment before maturity. Some short-term investment instruments are fairly illiquid. For example, a non-negotiable certificate of deposit is an illiquid asset that carries an interest penalty for early redemption. Another example of an investment that is illiquid before its final maturity is commercial paper. The ability to sell commercial paper prior to maturity is dependent on the willingness of the issuer to repurchase the paper from investors since there is no secondary market (the market where securities are sold after their initial issuance) for short-term commercial paper.

Closely related to liquidity risk is the concept of marketability—the ability to sell an instrument on short notice without incurring a significant loss in price. An active secondary market will enhance an instrument's marketability.

Market risk. Market risk is the risk that changes in the financial market will reduce the value of a security. For example, as interest rates rise, bond prices will fall. In periods of rapidly rising interest rates, the market value of a debt instrument can fall below the principal amount invested. If a government sells the security before maturity, part of the principal will be lost. This was the case with mortgage-backed derivative products whose values plunged below the par value (face value) of the securities in the fall of 1994. Investors can reduce market risk by limiting the number of instruments in the portfolio that are subject to rapid market swings.

Interest rate risk. Interest rate risk is the risk that investors will be holding an investment with a lower yield than the current market rate and, hence incur an opportunity cost by under performing the market. For example, if an investor held a one-year certificate of deposit earning 5 percent and interest rates rose to 7 percent, the investor would incur an opportunity cost of 2 percent. Investors can avoid interest rate risk by keeping maturities fairly short if interest rates are expected to rise.

2.2. POLICY STATEMENT

The primary objectives of the investment activities of First 5 commissions, in priority order, are legality, safety of principal, liquidity, and yield.

2.3. PROCEDURES

2.3.1. Written Investment Policy

Commissions should have a written investment policy that specifies acceptable investment instruments and establishes an acceptable level of risk related to return.

2.3.1.1. Content of the Investment Policy

California law contains no provisions specifying what must be included in a local agency's investment policy. However, the investment policy of a county government must contain the following:

According to the GFOA Sample Investment Policy, an investment policy should cover the following topics:

The GFOA, the Association of Public Treasurers, and the California Debt and Investment Advisory Commission have each developed model investment policies for local governments. Commissions should adapt these model investment policies to their match their investment strategy and method. For example, commissions that invest solely in their county’s local government investment fund may not need to include a section on competitive bidding for investment securities.

2.3.1.2. Submitting the Investment Policy to the Commission

California law, Government Code Section 53646(a)(2) requires the treasurer or chief fiscal officer of any local agency to annually render to his/her legislative body an investment policy and, if applicable, his/her oversight committee, which the legislative body shall “consider” at a public meeting. The investment policy must be an agenda item at a public meeting of the agency's legislative body at some time prior to or during the year it covers. More specifically, section 53646(b)(2) states “The quarterly report shall state compliance of the portfolio to the statement of investment policy…”, which implies that the investment policy must be an agenda item at a public meeting prior to completion of the first quarterly report of the year. The law does not place specific approval requirements on local agencies, nor does it specify when during the year that consideration or approval must occur.

Although California law does not require public agencies to submit an investment policy to their legislative body for annual review, this is recommended by the GFOA, the Association of Public Treasurers, and the California Debt and Investment Advisory Commission.

2.3.2.  Responsibility for Investment Management

For commission funds invested in the county treasury, the county treasurer serves as a fiduciary and is subject to the prudent investor standard. Except as provided for in Government Code Section 27000.3, Section 53600.3 declares each person, treasurer, or governing body authorized to make investment decisions on behalf of local agencies to be a trustee and therefore a fiduciary subject to the prudent investor standard. These persons shall act with care, skill, prudence, and diligence under the circumstances then prevailing when investing, reinvesting, purchasing, acquiring, exchanging, selling, and managing funds.

Government Code Section 53686 requires that reports and/or audits concerning investments that are prepared by county treasurers must be provided to local agencies that have funds deposited in the county's investment pool.

Section 53600.5 stipulates that the primary objective of any person investing public funds is to safeguard principal; secondly, to meet liquidity needs of the depositor; and lastly, to achieve a return or yield on invested funds.

According to Section 53600.3, the commission can delegate duties to an external money manager via a principal-agent relationship, but they cannot delegate fiduciary responsibility . Further, to be consistent with best practice, contracts with external managers should allow them to make specific decisions within an established framework. Commission executive directors or their designated representatives should closely monitor the actions of these individuals to ensure they are consistent with the commission's investment policy and philosophy, and demand that external managers provide timely reports that comply with the requirements of state law.

The following list summarizes commissions’ investment management responsibilities, whether the commission actively makes and manages its own investments or simply exercise oversight over investments held in an investment pool:

2.3.3.  Permissible Types of Investments

Model Allowable Investment Instruments and Model Allowable Short-Term Investment Instruments provide a synopsis of the permitted securities and conditions for using them (Sections 16429.1, 53601, 53601.6, 53601.7, 53635, 53635.2, and 53684). Best practice is for the commission to select investments from this list in order to make its own list of permissible investments based on its unique needs and risk tolerance.

In addition to the allowable investments listed in Model Allowable Investment Instruments and Model Allowable Short-Term Investment Instruments, money may be deposited for safekeeping in the following (Section 53635.2):

To be eligible to receive local agency money, the financial institution must receive an overall rating of not less than “satisfactory” from the appropriate federal supervisory agency for meeting the criteria specified in Section 2906 of Title 12 of the United States Code (Community Reinvestment Act of 1977). The Community Reinvestment Act of 1977 requires financial institutions to demonstrate their commitment to meeting the credit needs of local communities in which they are chartered to do business. For the purpose of the Act, the appropriate federal supervisory agency includes:

A local agency would need to contact the appropriate federal supervisory agency to determine if its financial institution meets the overall rating requirement.

Prohibited investments include securities not listed in Model Allowable Investment Instruments and Model Allowable Short-Term Investment Instruments, as well as inverse floaters, range notes, interest-only strips derived from a pool of mortgages, and any security that could result in zero-interest accrual 1 if held to maturity, as specified in Section 53601.6.

Where the Government Code specifies a percentage restriction on a certain category of investment, this share of the investment portfolio must be in compliance with state law at the time that investment is purchased. The law does not specify that the entire portfolio must be in compliance when new instruments are purchased. It also does not require “rebalancing” in the case where subsequent maturities, sales, withdrawals, or similar non-purchase activities result in the remaining portfolio having one or more of the categories of investment rise above the percentage restrictions applicable at the time of purchase.

In addition, Government Code Section 53601.7 specifies (for investments purchased pursuant to this section) that any credit rating downgrade of an investment subsequent to purchase shall result in the security being reviewed for possible sale within a reasonable amount of time after the downgrade.

2.3.4.  Use of the Local Agency Investment Fund (LAIF)

A local government investment pool (LGIP) is a pooled investment fund that operates like a money market mutual fund for the exclusive benefit of governments. Commissions have access to the State of California’s Local Agency Investment Fund (LAIF). LAIF was established in 1977 and is administered by the Treasurer’s Office. Oversight is provided by the Pooled Money Investment Board (PMIB), which consists of the State Treasurer, Director of Finance, and State Controller, and the Local Investment Advisory Board, which consists of the State Treasurer, two members qualified by training and experience in the field of investment, and two finance officers or business managers of any county, city, local district, or municipal corporation in the state.

LAIF combines the cash of participating jurisdictions and invests the cash in securities allowed under state code section 16430 and 16480.4. By pooling funds, participants benefit from economies of scale, full-time portfolio management, diversification, and liquidity. The PMIB has policies in place to ensure the goals of safety, liquidity, and yield are met and that prudent investment management is practiced. LAIF has grown from 293 participants and $489 million in its inception to approximately 2,700 participants and over $24 billion assets as of July, 2008.

According to section 16429.4 of the state code, participating jurisdictions and entities cannot be denied the right to withdraw monies deposited in LAIF based upon the state’s failure to adopt a budget by July 1 of the new fiscal year. In addition, monies in LAIF are not subject to transfer, loan, impoundment, or seizure by any state official or state agency.

The checklist below provides important guidance for using investment pools such as LAIF:

Additional information about LAIF can be found on the California State Treasurer Web site.

2.3.5.  Maturities of Investments

According to best practice, the commission should attempt to match its investments with its anticipated cash flow requirements. In other words, funds needed to meet cash flow requirements in the near future should be invested in more liquid, short-term investments, while reserve funds intended to be used in future years should be invested in longer-term investments that still preserve the safety of the principal and match cash flow requirements, but earn higher returns. For these reasons, commissions should consider completing periodic cash flow analyses and developing a cash flow document.

According to California law, there is a five-year maturity limit on permissible investments. However, local agencies may invest funds in securities with maturities exceeding five years if the local agency's legislative body specifically approves the investment no less than three months prior to the purchase of the security (Government Code Section 53601). Part of that approval process involves assessing and disclosing the risk and possible volatility of longer-term investments.

According to best practice, reserve funds and other funds with longer-term investment horizons may be invested in securities exceeding five years if the maturities of such investments are made to coincide as nearly as practicable with the expected use of funds. Because of inherent difficulties in accurately forecasting cash flow requirements, a portion of the commission's total investment portfolio should be continuously invested in readily available funds such as local government investment pools, money market funds, or overnight repurchase agreements to ensure that appropriate liquidity is maintained to meet ongoing obligations.

Ability of some commissions to invest funds in longer-term investments. Commissions that are county agencies are controlled by their counties' investment policies and procedures. County governments typically make relatively short-term investments in order to meet cash flow requirements, and this approach is reflected in their policies and practices. However, based on some commissions' long-term plans for use of reserve funds and consequent lower liquidity requirements for the total amount available for investment, it may be possible to work with a county's investment managers and policy makers to implement changes in policy and procedure that maintain the safety of principal and meet commissions' liquidity requirements, but earn higher yields.

2.3.6.  Internal Controls for Investment Management

An important step toward the prudent investment of public funds is to organize and formalize investment-related activities. Internal controls for the investment function are important to safeguard the commission's assets (cash and securities) and to ensure accurate and timely financial reporting. The commission's assets need to be protected not only from theft, fraud, and embezzlement, but also from inappropriate or poor decision-making.

To control the investment function, the local commission should rely on a combination of organization designs, systems and procedures. These can be summarized as follows:

2.3.7. Safekeeping

According to California law (Sections 53601 and 53608), as long as the securities for safekeeping are in the name of or under the control of the agency and kept in a legally separate trust department, they can be held by the same firm from which they were purchased.

However, best practice is to use a safekeeping service that is not related in any way to the company who sold the securities. Agencies should strive to “perfect” the delivery of securities purchased by avoiding situations in which a relationship exists between the broker-dealer and safekeeping provider. Even in situations when the safekeeping function is in a subsidiary or trust department that is legally independent of its parent company, strong ties between the two may remain. In the event that the parent company fails, local agencies may have some difficulty in regaining possession of their securities from the subsidiary or trust department.

2.3.8. Investment Performance Benchmarks

The commission will select investment performance benchmarks that match its legally authorized investments, investment policy constraints, and cash flow requirements. It may be appropriate to segregate the commission's total investment portfolio into more homogenous types of investments. For example, the commission might have one benchmark for its short-term cash investments and a separate benchmark for its long-term reserves.

Below are two sources of investment rate of return data and an assessment of California local government investment pools:

2.3.9. Investment Reporting to the Commission

Government Code Section 53646 states that all local agencies may file investment reports on the status of their investment portfolios with their respective legislative body, internal auditor, and chief executive officer.

When report must be submitted

The report must be submitted within 30 days after the end of the quarter. The commission may elect to require the report monthly.

What the report must include

The investment report must include the following information:

When the investment report is not required

This investment report is not required if all of the commission's funds are deposited in the following types of investments:

If all of the commission's funds are deposited in the above types of investments, in place of an investment report, the following information must be submitted to the legislative body, internal auditor, and chief executive officer:

2.3.10. Selection of Investment Advisors

The services of investment advisors range from advice-only consultation to fully discretionary management. The Government Finance Officers Association (GFOA) recommends that state and local governments exercise caution and prudence in their selection of investment advisers, particularly because the responsibility for safety and liquidity of governmental funds cannot be delegated to an investment advisor. (An excellent resource on selecting and evaluating investment advisors is GFOA's An Introduction to Investment Advisers for State and Local Governments.)

GFOA urges state and local governments considering or retaining an investment advisr to develop policies regarding the procurement and periodic selection of investment advisory services.

In accordance with state and local law or other requirements, these policies should address the following:

  1. The responsible public official or the governing board should appoint a consultant and/or review committee to conduct the search process. Such consultant and/or review committee members should be independent and free of any special interests in any investment advisory firm under consideration.

  2. A competitive, merit-based procurement process for selection should be employed.

  3. Responsibilities of the investment adviser and/or investment manager should be stated.

  4. The consultant and/or review committee should determine the criteria to be used in the selection. Criteria should include but are not limited to:

    • Investment style
    • Years in business
    • Assets under management
    • Investment performance versus appropriate benchmarks over an agreed upon period of time
    • Delivery of SEC Form ADV Part I and Part II (including Schedule I) prior to contract execution

  5. The consultant and/or review committee should determine the sources for candidates to be considered, including but not limited to:

    • Consultants database(s) on investment advisory firms
    • Industry reports and articles
    • Marketing materials
    • References from other jurisdictions
    • Special research and reports in order to ensure diversity in candidate pool
    • Other governmental entity resources and information

  6. The consultant and/or review committee should perform due diligence on candidates, including but not limited to:

    • Quantitative information (financial stability and performance review)
    • Organizational structure of firm
    • Experience and depth of personnel in firm, including turnover
    • Firm-specific investment philosophy and portfolio management strategies
    • Trading process
    • Management fees
    • Ability to communicate investment information clearly to lay people
    • References from other clients
    • Interviews with finalists
    • Use of a request for proposal (RFP) process

After the consultant and/or review committee has made a recommendation regarding the selection of an investment advisor, the contract process should include the following:

The finance officer managing the investment advisor contract should comply with the following ethical considerations:

The commission should develop and implement an ongoing risk control program, including:

2.4. MODEL DOCUMENTS

2.5. RESOURCES

Notes
1 Zero-interest accrual means the security has the potential to realize zero interest depending upon the structure of the security. Zero coupon bonds and similar investments that start at a level below the face value are legal because their value does increase. Return to reference point

2This includes all of the securities, investments and monies for which the local agency exercises control or are in its possession. Control implies that the local agency has some discretion to determine how the funds are invested. Possession implies that the local agency has at least a safekeeping role. This standard ensures the broad reporting of local agency investments contemplated by the Legislature. Thus, the report should include the following items:

3 Best practice recommends that the name of the investment managers and the nature of the contracts also be reported. Return to reference point

4 The market valuation data in the report should represent the agency's best available information and fairly represent the value of the portfolio, in the judgment of the investment officer. According to best practice, staff should obtain an independent valuation of the portfolio to provide the most unbiased method of reporting current market values. In situations where an agency's budget does not allow independent valuations, the agency should use the best available sources of market price information available. A system can be created to track prices from different sources over time to evaluate the sensitivity of price estimates, but there is no standard for accuracy. Prices for securities are estimates that carry a certain degree of error regardless of the approach used and they will fluctuate due to market conditions over time. It is imperative that local officials pay extra attention to estimates on complex, infrequently traded, or highly customized securities. Return to reference point

5Best practice recommends that staff regularly prepare and update a cash flow analysis to justify the expenditure statement in the report. This analysis may list basic projections—based on historical data, market sensitivity or other relevant information—that support the cash flow liquidity statement. There are no guarantees when it comes to predicting future obligations. A sound justification for the expenditure statement gives the finance officer added protection against decisions that originally looked good but turned out poorly because of unforeseen circumstances. The treasurer should be prepared to discuss cash flow projections and methodology at the request of legislative and/or oversight bodies. Return to reference point