Innovations in managing public funds: benchmarking and total return.

• Author: De Foor, Joya C.
• Position: Cover story

Like most local governments, the City of Los Angeles, California, spent years looking under every budgetary rock in search of more funds for police and fire protection, education, parks, community services, and other important projects. But in 2001, Los Angeles discovered a way to better use its existing resources to increase revenue. With new leadership in its treasury department, the city began a careful review of how its greatest earning asset, its $3 billion investment portfolio, was being managed. City officials were concerned they might be sacrificing significant funding for services and projects because the portfolio's earnings potential was being underutilized.

Upon completing its review, the city discovered that its approach to investment management was neither well-defined nor properly disciplined. The situation almost certainly led to lost revenue opportunities. The review of the city's portfolio made it clear that it had greater liquidity than necessary. The city's financial management team decided to revamp its investment approach, using methods that are generally considered innovative in managing public operating funds, though are more common among private investment professionals. The new approach consisted of three steps: segmenting the portfolio (dividing it between funds that require high liquidity and funds that can be invested long term for higher return), benchmarking performance against an appropriate index, and measuring and evaluating the portfolio's total rate of return.

As a result of these changes, Los Angeles today enjoys portfolio returns well above the state average, which add much-needed revenue yet maintain high levels of safety and liquidity.

SEGMENTING THE PORTFOLIO

Segmenting an investment portfolio typically enables the holders to realize significantly higher rates of return on funds that can be "locked in" for a long period of time, rather than leaving the entire portfolio invested for maximum liquidity and therefore placed in short-term investments only. Los Angeles had to begin by analyzing cash flow in order to determine how much liquidity the city actually needed to fund its day-to-day operations and capital projects. Because liquidity is second only to safety in importance in the public sector (in fact, some argue they are equal), it was essential to understand the pattern of funds inflows and outflows before the city could prudently consider any new investment approach.

Once the fund managers understood how much liquidity was needed in the portfolio for cash management, they also knew what percentage of funds could be made available for longer-term (and thus potentially higher revenue) investments. Understanding its liquidity needs allowed the city to structure two segments within its overall portfolio that had very different investment objectives, the liquidity portfolio for immediate cash availability and the reserve portfolio for enhanced earnings and long-term growth.

Los Angeles' liquidity portfolio has been structured to provide sufficient funds for net disbursements in the ensuing six months, with a cushion for any unexpected cash draws. Since its establishment, its average maturity has generally been less than one year, with a high proportion invested in very short term securities. To date, the liquidity portfolio has successfully maintained sufficient liquid funds to meet all of the city's cash needs.

The reserve portfolio, consisting of funds the city does not expect to draw down in the foreseeable future, has been intentionally structured quite differently in order to achieve higher expected returns. The reserve portfolio has securities with longer maturities and diversified credit risk. However, all of the securities have active markets and excellent liquidity to provide for an unexpected event requiring liquidation of securities. The risk profile for this segment of the city's portfolio has been determined by factors such as the California Government Code, which governs the investment of public...