Building an Investment Policy: A Guideline for Understanding the Key Elements

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Building an Investment PolicyA Guideline for
Understanding the Key Elements

AFP2000 Annual Conference

• Michael Gallanis Project Manager

www.TreasuryStrat.com 312.443.0840
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Agenda

• Introduction
• The Investment Landscape
• The Value of a Formal Investment Policy
• The Development Process
• The Blue Print
• How the Formal Investment Policy Mitigates Risks
• Insufficient/Ineffective Controls can be Costly

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Treasury Strategies, Inc.

• Founded in 1982
• Consults on matters related to
• Treasury operations
• Treasury performance
• Treasury technology
• Payment systems
• Liquidity management
• Clients include users and providers of treasury
  services
• 20 consulting professionals
• Offices in Chicago and New York

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The Investment Landscape

• US corporations have approximately 3.6 trillion
  invested in short-term instruments
• Active investments comprise over 80 of total
  operating liquidity

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Total Corporate Liquidity

Passive Investments .7 trillion
Commercial Paper 1 trillion
Other Investments 1.3 trillion
Total Corporate Liquidity
Offshore Investments .6 trillion
3.6 trillion
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The Investment Landscape

• The dynamics of investment are changing
  constantly
• Investment alternatives are increasing
• Transaction mediums are changing with new
  technology
• Regulatory changes are constantly underway
• Corporations are changing in size and
  configuration

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The Investment Landscape

• Technology presents new opportunities and risks

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The Investment Landscape

• Formal investment policies are an important tool
  for directing and managing the investment process

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The Value of a Formal Investment Policy

• Provides global clarity
• Decentralized and/or global operations
• Larger/complex organizations
• Formalizes process procedures
• Who , what, where, when, why

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The Value of a Formal Investment Policy

• Encourages best practices
• Formal process to establish procedures/practices
• Establishes discipline with regard to review
  self-assessment
• Enhances controls reduces risk
• Establishes boundaries
• Establishes benchmarks measurements

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The Development Process

• Assess status
• Firms are at different stages in the development
  process
• Review all existing investment policy
  documentation
• Determine the extent of work required (overhaul
  or develop from scratch ?)

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Policy Assessment Test

• Instructions Record a 1 for each yes and 0 for
  each no.
• 1. Does your firm have a current investment
  policy (i.e., updated in the last 12 months?) ___
• 2. Does your policy list the correct person(s)
  responsible for making approving policy
  modifications, and for approving policy
  exceptions?___
• 3. Does your policy contain a current and
  accurate list of investments approved for
  inclusion in the companys portfolio?___
• 4. Does your policy define all required
  investment reporting (including frequency, type
  and distribution)? ___

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Policy Assessment Test continued

• 5. Does your policy define the measurements,
  benchmarks and return calculations that are to be
  used to assess portfolio performance? ___
• 6. Does your policy define the periodic review
  and compliance steps that will be taken to ensure
  procedural compliance? ___
• 7. Does the policy define the investment
  accounting/ reconciliation process? ___
• Total Score ____

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The Development Process

• Who to include in the development process
• Identify a champion to lead the charge
• Obtain assistance from key areas of the business
  ( i.e.,Treasury, Tax, Accounting, Audit, Legal )
• Who approves modified or newly developed
  policy?
• Plan the work and work the plan
• Build sufficient check points into the process
  for circulating drafts and making revisions

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The Blue Print

• The starting point - setting policy objectives
• Establish the appropriate balance between
• Safety
• Liquidity
• Risk/return

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The Blue Print

• Safety
• Establish what constitutes a safe investment
• Define the tools that will be used to assess
  investment safety
• Credit Ratings
• Financial ratios
• Rankings in terms of total assets or total
  deposits
• Ensure that safety measurements are reviewed on a
  regular basis
• Financial conditions can change very quickly

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The Blue Print

• Liquidity
• Most entities define liquidity as the ability to
  convert an investment into cash with minimal risk
  of loss
• Define your firms liquidity needs
• Establish clear guidelines as to how and when
  investments will be converted to cash instead
  of holding to maturity

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The Blue Print

• Risk/return
• It is important for a firm to understand the
  importance of return as compared to other
  objectives
• Many types of risk are present in the investment
  arena
• Credit risk
• Interest rate risk
• Currency risk
• Sovereign risk
• Define the firms risk profile

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The Blue Print

• Define the scope of the policy
• Entities areas covered by the policy ( i.e.,
  policy may cover corporate short-term activity
  but not retirement plans ).
• Develop an approved list of investments
• Active or Passive investments?
• Research suggests that active investments
  comprise over 80 of total corporate operating
  liquidity

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Commonly Used Short-term Instruments
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The Blue Print

• Establish diversification strategy/requirements
• Limitations by instrument
• Limitations by dollar amount
• Limitation by broker
• Investment horizon/duration
• Other components
• Use of internal vs. external managers
• Custodial services
• Exception management
• Performance measurement, benchmarks and reporting

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Performance Measurement

• The method used to calculate the return
  achieved by a portfolio should be clearly defined
  within the policy
• The return calculation should be consistently
  applied
• The return calculation must adjust for tax-exempt
  and tax-advantaged securities
• Pre-tax vs. after-tax

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Common Investment Benchmarks

• Specific Instruments
• U.S. Treasury securities ( bills, notes, bonds )
• Commercial paper
• Euro securities ( for foreign benchmarking )
• Indices
• AFP Investment Benchmarks
• Lipper Money Market Index
• S P 500
• Lehman Bond Fund Index
• Private Agency Rating Services
• Morningstar or IBC/Donoghue

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Reporting

• Daily activity reports
• Identify individual investments
• Change from prior day
• composition of portfolio

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Reporting

• Monthly Reports
• Narrative report focused on portfolio results,
  causes for change over prior report, and
  accounting impact

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Reporting

• Periodic and/or special purpose reports
• Annual YTD management reports
• BOD reporting
• Audit and financial statement reports/schedules

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How the Formal Investment Policy Mitigates Risks

• A policy establishes clear guidelines
• Roles and responsibilities
• Approved investment list
• Credit requirements
• Approvals and exception processing

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How the Formal Investment Policy Mitigates Risks

• It defines procedures and thereby reduces the
  risk of miscommunication and/or judgmental errors
• A policy outlines expectations
• Operational performance
• Accounting and reconciliation
• Reporting
• Compliance reviews

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Insufficient / Ineffective Controls Can Be Costly

• Barings Bank - 1995 scandal Unauthorized trading
  led to losses of approximately 1.2 billion
• Poor control procedures
• Poor segregation of duties

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Insufficient / Ineffective Controls Can Be Costly

• Orange County - 1994 County Treasurer realized
  a 1.6 billion loss in the Orange County
  portfolio
• Unsupervised trading
• Poor reporting/measurement tools ( i.e., VAR )

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Insufficient / Ineffective Controls Can Be Costly

• Daiwa Bank - 1984 to 1995 1 billion in
  fraudulent trading losses
• Poor supervision weak risk management process
  cited

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WHO WILL BE NEXT ????
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Conclusion

• The Investment Landscape
• The Value of a Formal Investment Policy
• The Development Process
• The Blue Print
• How the Formal Investment Policy Mitigates Risks
• Insufficient/Ineffective Controls can be Costly

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Building an Investment PolicyA Guideline for
Understanding the Key Elements

AFP2000 Annual Conference

• Michael Gallanis
• Project Manager

www.TreasuryStrat.com 312.443.0840
35
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