Author:Daniel, Christopher H.

The optimal investment of public funds for all types of portfolios and needs is grounded in the principles of safety, liquidity, and return. Governments aim to ensure that their constituent funds are safeguarded, that sufficient cash is on hand to meet obligations, and that cash assets earn a reasonable return. These three strategic principles must work in balance.

GFOA's best practices recommend that governments develop expected outcomes for their public funds investment programs. This article provides an overview of how best to develop benchmarking and performance measurements for types of investment funds used by governments.


The default public funds investment approach is often to establish separate cash/investment accounts for each primary type of governmental fund. In most cases this practice isn't required, and it results in inefficient investment management. Instead, a government can commingle its cash into an investment portfolio, leaving it to accounting staff to track the governmental fund cash balances. This approach permits the investment manager to strategically invest cash in accordance with two primary mandates, liquidity assurance and risk-managed return enhancement.

The two-portfolio approach can help ensure sufficient liquidity and a risk tolerance-based foundation, while managing the investment program as a value-added business unit.

Investing for Cash Flow/Liquidity Needs. A government can ensure liquidity and an understanding of cash flow needs to meet obligations by creating a liquidity portfolio and setting aside an amount equal to the government's expected net drawdown over the operating cycle, plus a cushion of an additional 10 to 20 percent. (See Exhibit 1 for an example of fund balance analysis.) Although the primary focus of this portfolio should be cash placement in stable-value instruments that offer immediate or T+1 cash conversion to meet near-term obligations, basic risk and return objectives for liquidity money should be established as well. These can be couched in terms of collateral requirements, placement concentration limits, short-term Treasury performance benchmarks, and others.

Intermediate-Term Investing. The residual and typically larger portfolio, often referred to as the core investment portfolio, can be managed more like an intermediate-term investment pool, notwithstanding statutory constraints and the overriding realization that core funds remain a contingent source of cash should liquidity portfolio funds be insufficient. To that end, and given that every investment opportunity carries some level of risk, public funds performance measures must be calculated and stated on a risk-adjusted basis. Let's briefly discuss the risk components, then the return measures, followed by how to combine these concepts and then compare them to a yardstick (benchmark) so we'll know if we're performing well or not.

Defining Risk (Safety). Let's define and briefly discuss the most prominent types of risk the public funds investment manager will encounter:

* Total Risk. The total of all sub-risks encountered. It's represented statistically as standard deviation, or the square root of variability (variance) based on the assumption of a normal distribution of returns. Total risk is best managed by a strategic asset allocation approach, whereby the investable sectors or asset classes are "optimized" to create an "efficient frontier" of portfolios that provide the asset mix most likely to earn the highest return for the level of total risk assumed--or, alternatively, offer the lowest total risk portfolio for the desired return.

* Interest-Rate Risk. The exposure of fixed-income portfolios to changes in market value based on the movement of market interest rates...

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