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When funds are commingled for investment purposes, the resulting product takes one of two shapes based on the accounting and structure of the portfolios. The two types of portfolios are 1) constant dollar funds/pools or 2) fluctuating net asset value funds/pools. Both are legitimate investment types but the investor has to be aware of the differences in order to use them effectively and with safety.
A constant dollar fund or pool is, by definition, short-term in nature. The portfolio is usually limited to securities no longer than 13 months and the primary objectives of the portfolio are safety and liquidity. A number of local government pools are established as constant dollar pools because they reflect the needs of the governmental entities for safety and liquidity. Rated and registered money market mutual funds are constant dollar funds. The yield benefits to the participant come from the economies of scale and professional management as opposed to longer term securities.
A fluctuating net asset value fund or pool is, by definition, a longer term portfolio. Except through its own investment policy, there are no limits on the maturities of the securities or the type of securities used. All mutual funds are fluctuating net asset value funds. The primary objective of the fund/pool is yield. There are local government investment pools which are structured as longer funds, but, these are usually restricted by maximum maturity and security type to reflect government's inability to use equities and corporate debt.
These distinction between the two types of securities and maturities used creates differences in the accounting of the funds. The difference is centered on the recognition of unrealized profits and losses.
The short, constant dollar portfolio attempts to maintain a stable net asset value of $1 and results in a stable steady rate. (Many pools, like LOGIC, have strict restrictions which prohibit the value from fluctuating from the $1 value.) Since the securities are short-term there is little volatility in their price. These portfolios recognize only realized profits and losses. Therefore, a market value higher than book value on the portfolio would not affect the earnings to the participant. The participant only realizes what the manager actually takes as profits and losses. This is reflected in the yield and the daily allocation factor. Because the portfolio is short, portions can be liquidated at the near $1 value without recognizing the market value shifts.
In accounting for the short term constant dollar you must track your daily allocation factor which will tell you the interest earned for the period. But, your market value will remain at 100 reflecting the stability of the portfolio.
The longer, fluctuating net asset value portfolio must allow its net asset value (or share value) to fluctuate with the market value. Liquidations from such a pool would require the manager to liquidate longer securities which are much more volatile (because of their longer maturity) and could result in market gains or losses. Therefore, in reporting and tracking such a fund, it is necessary to recognize the gains and losses in market value every day. It is this value which is reported to the participant as share value.
In accounting for the longer, fluctuating net asset value portfolio, you must track your daily share value. In reporting the value of your investment on monthly reports you must also recognize a gain or loss from your purchase price. (For example, if you bought at in $12/shares and the value now is $8/ share, you must report a $4 loss.)
Both of these can be good investments. However, the investor has to understand the differences in the portfolios' makeup and accounting must utilize them for different types of funds. If safety and liquidity are your highest objectives, and cash flows are indefinite, the more stable constant dollar fund is recommended. If you can afford the risk of longer term securities and the possibility of loss of principal, the yield on the longer fund may be appropriate. If you have long term money for a particular use (capital purchase or capital projects for instance), you can use the longer fund and monitor it for a profitable withdraw before the money is needed. A longer fund has to be traded as if it is a security you purchased for trading. This is not an investment you make and ignore! Start monitoring the funds closely about six months before the money is required then withdraw the shares and put them in a stable constant dollar fund until the money is needed.
Like any security investment, the investor is responsible for knowing the security and matching those securities to the objectives of the money being invested. Only in this manner can we assure the safety of public funds.
- Types of Risk
- (The Possibilities of Loss)
- Credit
- Risk that the issuer of a security may default. Credit risk is measured by quality ratings assigned by commercial rating companies such as Moody's, Standard & Poor's and Fitch Investor's Service.
- Liquidity
- Risk that a security may not be able to be sold. In an active market there should always be buyers available. On small or "private" issues liquidity may be limited and no buyer found. One measure of possible buyers and market activity is the spread (difference) between the bid and offer price. In active (liquid) markets, the spread, will be small because demand is high. In inactive (illiquid) markets, the spread will be much wider to attract buyers and sellers.
- Market
- Risk that the market will move against you and the value of your security will decrease. As interest rates rise, the price of an fixed income security falls. For an investor who plans to hold a fixed income security to maturity, the change in market price prior to maturity in not of concern, however, for an investor who may need to sell the security prior to maturity, an increase in rates (prices dropping) will mean the realization of a capital loss.
- Volatility
- Risk that market changes will move the price of a security to a larger degree on one security than another. Certain attributes of a security, such as a long maturity date or an embedded option (such as call features), will cause a security to exaggerate the effect of market changes. For example, when interest rates increase slightly, a Treasury Bill will be decreased only slightly while in the same environment, a mortgage-backed security's value may plummet.
- Extension
- Risk that a change in interest rates will cause the anticipated maturity of a security to extend. An example would be a mortgage-backed security, which has been paying off faster than its stated maturity date as homeowners refinance. In such a case, investors typically assume this accelerated payment will continue and will calculate the "average life" of the investment as shorter that the stated. When interest rates rise, however, homeowners may cease refinancing and the average life of the security will snap back to its much longer stated maturity date.
- Re-investment
- Risk that the cash flows generated by a security will have to be reinvested at a lower rate than the prevailing interest rate levels. The risk is most critical for mortgaged-backed and callable securities. If rates fall and mortgages pre-pay faster than expected or if a security is called when interest rates fall, the investor is faced with having to reinvest the proceeds in a lower rate than the security he held previously.
- Collateral
- (1) Risk that the market value of underlying collateral will decrease and be inadequate to cover the investment plus interest accrual in a counterparty default. A "margin" (additional percent) of collateral protects the investor from changes in value until additional collateral can be pledged.
(2) Risk that the investor's right of ownership to the collateral will not be "perfected". A third (neutral) party holding the collateral in the investor's name can reduce this risk. Repurchase agreements should always be governed by an executed PSA Mas ter Repurchase Agreement between the investor and the dealer to reduce both these types of collateral risk.
- Event
- Risk that an unforeseen event could negatively impact the value of a security. An example would be the Orange County bankruptcy and its impact on the participants in the investment pool managed by Orange County. Not only were the participants' funds withheld, but their credit ratings were impacted by their lack of liquidity. Investors who held bonds issued by the governments saw the value of their securities decline.
| Risk: | Credit Risk: | No |
| Liquidity Risk: | No. Largest, most liquid market in the world. | |
| Market Risk: | Yes. Volatility of prices on longer securities. |
| Risk: | Credit Risk: | Yes. Ratings must be monitored |
| Liquidity Risk: | Yes. Small issues may not have buyers. | |
| Market Risk: | Yes. Volatility because of size of issue or long-term maturities. |
| Risk: | Credit Risk: | Yes. Ratings and news events must be monitored |
| Liquidity Risk: | Yes. Small issues may not have buyers. | |
| Market Risk: | Yes. Volatility and Event Risk. |
| Risk: | Credit Risk: | No. Because of agency issuance |
| Liquidity Risk: | Yes. Securities can extend and significantly lose value.. | |
| Market Risk: | Yes. Extension and Volatility risk is high. |
| Risk: | Credit Risk: | Yes. Ratings should be monitored. |
| Liquidity Risk: | Yes but Moderate. | |
| Market Risk: | No. Because of short term nature of the security. |
| Risk: | Credit Risk: | No. Not if covered by a Master Repo (PSA) Agreement. |
| Liquidity Risk: | No. Not if covered by a Master Repo (PSA) Agreement. | |
| Event Risk: | Yes. Monitor credit ratings of counterparty. | |
| Market Risk: | Yes. Price collateral regularly and require adequate margins. |
| Risk: | Credit Risk: | Yes. Ratings of company issuing paper should be monitored. |
| Liquidity Risk: | Yes. Moderate if company has credit problems. | |
| Market Risk: | No. Because of short term nature of the security. |
| Risk: | Credit Risk: | Yes. Monitor financial conditions of bank. |
| Liquidity Risk: | Yes. Total illiquidity without paying penalty. | |
| Market Risk: | Yes. Monitor collateral value and require adequate margins. |
| Risk: | Credit Risk: | Yes. Monitor financial conditions of bank. |
| Liquidity Risk: | Yes. Total illiquidity without paying penalty. | |
| Market Risk: | Yes. Monitor collateral value and require adequate margins. |
| Risk: | Credit Risk: | No/Yes. No credit risk on securities. Some risk on pool rating. |
| Liquidity Risk: | No/Yes. Nominal risk on constant dollar. Substantial risk on fluctuating NAV pools with share value. | |
| Market Risk: | No/Yes. None on constant dollar because of $1 value caps.Substantial risk on fluctuating NAV because of volatility and length.. |
| Risk: | Credit Risk: | No/Yes. No credit risk on securities. Risk on fund rating. |
| Liquidity Risk: | Nominal risk because constant dollar. | |
| Market Risk: | Limited due to short term average maturity. |
| Risk: | Credit Risk: | Yes. Monitor fund rating. |
| Liquidity Risk: | Yes. High because of long term nature of securities. | |
| Volatility Risk: | Yes. High because long term. Monitor net asset value. | |
| Extension Risk: | Yes. High. Monitor net asset value and check holdings. |
There is risk along with opportunity in the markets. The realities of time constraints as well as technical and training requirements clearly indicate the need for professional management. External money managers provide needed support for your efforts at improving treasury as a critical part of financial operations. They are not on-site temporarily as other consultants but play a role as a daily resource and tool for your treasury.
Independent investment advisors such as Patterson & Associates provide significant advantages. We act as your extended staff to get the most from your assets. With extended staff, your internal staff can be better utilized and you retain the control you need for your fiduciary responsibility.
Practical experience in treasury management can help you save time and find the most efficient means of operation.
Managers can identify inefficiencies and exposures in your program.
Managers improve your access to technology and managerial skills that are state-of-the-art giving you the benefit of the experience, technology and judgement without a major capital and human resource investment.
Independent registered investment advisors bring an unbiased access to the market that is not available through managers funded by, or part of, a broker/ dealer firm. This independence clearly separates us from other financial services provided by underwriters or financial advisors not involved daily in the investment arena.
Managers work in evaluating and improving your systems and operations with you to assure that you develop and retain the needed control and better understanding of your operations.
Under a funds management contract, funds are strictly invested in accordance with the entity's own investment policy. The existing depository bank of that entity is utilized to assure the highest level of security and safety.
All the funds under management receive the personal attention of the experienced principals of the firm and the benefits of professional management.
Professional money managers structure, monitor and trade your portfolio for increased yield with safety. They are a value-added service.
External managers have the technology to timely monitor the markets through state-of-the-market technology and use the markets more effectively.
Managers provide professional presentations to governing bodies on portfolio status and performance.
Managers provide daily pricing of the portfolio by an independent pricing service for accurate market pricing.
Managers provide customized reporting.
Managers provide diversification of your portfolio allowing the entity to maintain liquid funds in local government investment pools while better utilizing their assets. Diversification of the portfolio extends to diversity by market provider, market sector and maturity.
Managers provide access to a broader range of the best broker/dealer network which is constantly monitored as to credit quality and service. The wide range of brokers used by Patterson & Associates gives you competitive access to the market makers because of the size portfolios being managed by the firm.
Some of the additional services and skills an external manager can bring include:
All these services would be part of a total discretionary funds management contract. By combining discretionary management with cash management consulting you have assured yourself of a well balanced investment program which includes the two most important aspects of treasury: (1) a well managed, balanced and progressive portfolio under professional management which addresses your liquidity needs and can extend slightly in order to capture market rates for longer term funds, and (2) a well thought-out and developed foundation of policies and systems to underpin your portfolio.
A Patterson & Associates professional would be glad to review all the advantages of external management with you.
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