Beyond total return: using a fiduciary standard to evaluate investment performance.

• Author: Finkelstein, Benjamin

The nature of public fund investing is unique. As stewards of public moneys, government portfolio managers have the fiduciary responsibility to ensure that investments are suitable. The Wall Street approach to investment management and performance evaluation does not apply to the investment of public funds. But this raises the question: What is the most appropriate measure of investment performance for state and local governments? If it is not Wall Street's total return measure, then what is it? Is it comparison to peers, as some suggest, or is it something totally different?

If we were to ask a room full of public fund managers to rank, in order of importance, the investment objectives of safety, liquidity, and yield, most would rank either safety or liquidity as the most important objective. Yield would invariably rank as the least important of these objectives. Why, then, is the performance of public investments typically based on total return?

Peer group comparisons also are an inadequate measure of investment performance. How can such comparisons provide useful insight into how well a public fund performed relative to its peers when no risk adjustment or standard return calculation is provided? Just because several governments have similar investment policies and objectives does not necessarily mean they have the same liquidity and risk tolerance. Thus, the only relevant "peer group" for a state or local government investor is its own investment policy and plan.

A good measure of investment performance is one that captures all investment policy objectives, not just yield. The most suitable benchmark is a fiduciary benchmark that adds a qualitative component to the quantitative measures commonly used by investment managers. We propose a performance measurement standard that allows investment practice to follow investment policy. In this article, we explain why total-return market benchmarks are a poor measure by which to judge the fiduciary performance of state and local government investment portfolios and suggest a way to modify a market benchmark to capture the unique investment objectives of public entities.

A TALE OF TWO CITIES

Picture the following scenario: A local government portfolio manager says, "I have great news! We are in the top 1 percent quartile of all professional money managers based on the Merrill Lynch 1-3 Year Treasury Index. We realized only a 5 percent portfolio loss, while the Merrill Lynch benchmark lost 5.5 percent." Needless to say, most city managers and local elected officials would not share this portfolio manager's enthusiasm.

This vignette illustrates the problem with judging investment performance by comparing your returns to a market benchmark or to another government's returns. Comparing returns does not capture the qualitative elements of performance evaluation, such as the differences in risk tolerance between the two governments. Focusing exclusively on yield may obscure the fact that neither government's portfolio is suitable.

Consider two hypothetical cities--City A and City B. The cities are located in the same state and have approximately the same...