By Dwight Buracker, CPA, CVA
Our government clients work diligently to meet portfolio objectives and generate investment returns that are appropriate for the level of risk incurred. As they progress toward these goals, strategic use of benchmarks can be extremely helpful.
In this article, we’ll discuss recommendations from the Government Finance Officers Association (GFOA) about best practices for measuring portfolio risk and return against market indexes and benchmarks.
Investment Yield Alone Is Not Sufficient
As a benchmark, investment yield alone does not sufficiently enable government entities to assess risk and performance for several reasons, including:
- Because there are several ways to define investment yield (market yield, yield to maturity, yield to call, etc.), using this metric alone can lead to inaccurate analysis.
- Distorted data. Timing issues related to current interest rates and possible call options can distort investment yield data.
Because investment yield measures a portfolio’s increase or decrease during a given period, it can be useful for budgeting purposes. However, on its own, this metric is not reliable enough to drive decisions about effective risk assessment.
Government investors should assess their investment portfolio for performance and risk by comparing the total return of the portfolio to carefully selected benchmarks.
Total return measures the percent change in value of a portfolio during a defined period. As such, total return can provide a comprehensive snapshot of the outcomes resulting from investment decisions.
How to Select Benchmarks for Governmental Entities
Below, we’ve summarized GFOA guidance on how to select and manage benchmarks.
Each benchmark should be:
- Selected with the portfolio holdings in mind. Benchmarks should make sense for the composition of the portfolio holdings. Be sure to consider characteristics including policy constraints, duration, maturity range, average duration, security types, sector allocations, credit quality, etc.
- Unambiguous and transparent. Benchmarked investment categories and percentages should be clearly quantified and labeled.
- Benchmarks should only include securities an investor can easily obtain in the market.
- Supported by historical data. Past returns of the benchmark should be easy to find.
How to Manage Benchmarks for Governmental Entities
Benchmarks should be:
- Benchmarks should be listed in a consistent manner for ease and continuity of ongoing comparison.
- Priced on a regular basis. Returns should be calculated periodically.
- Specified in advance. Benchmarks should be adopted prior to evaluation.
- Regularly published with risk metrics. Detailed risk metrics associated with the benchmark should be readily available.
Frequency of Risk and Return Assessments for Governmental Entities
The GFOA recommends that total return comparisons against benchmarks should occur at least quarterly. Such reviews should be performed more often in the following circumstances:
- Portfolios managed by external providers
- Portfolios containing significant investment amounts
When Results Differ From Benchmarks
When total returns are significantly more or less than the selected benchmark, those variations should be seriously considered and the portfolio risk profile should be revisited.
Take a Proactive Approach to Assessing Portfolio Risk
While each government entity requires a unique investment approach, all government investors must act with their fiduciary responsibility in mind.
Developing a comprehensive investment program is essential to proactively managing finances for government investors. By establishing benchmarking protocols, government entities can seamlessly navigate changing economic conditions and communicate with stakeholders.
Although establishing an effective investment strategy takes time, effort, and training, a well-developed approach provides the structure necessary to make impactful decisions and safeguard a government’s financial assets.
Our team can simplify and streamline the process. Contact us today for a complimentary consultation.