Patterns of Investment Behaviour

1. Patterns of Investment Behaviour Mike Griffiths The Treasury Management Forum

2. New Investment Freedoms • March 2004 – ODPM/NAW Guidance • Effects: • Remove past restrictions on types of investment LAs might use to invest surplus cash • Require LAs to create policies and systems to control risk exposures, especially for higher risk/limited liquidity investments

3. The Case for Relaxation • Investment returns historically low • Growth of local authority cash surpluses • Surpluses had become more long-term, warranting more permanent approach to investment • Dearth of high quality, low risk outlets using traditional instruments and techniques • Comparisons with other public service bodies demonstrated LAs relatively limited powers

4. CIPFA Treasury Management Panel – Survey of Local Authority Investment Practices and Patterns • Evidence collected by CIPFA and other sources suggests use of new powers has been limited • May 2006 – Panel agreed to survey local authorities to assess extent to which this is the case • And if so, why?

5. Scope of the Survey • Are you clear about extent of new freedoms? • Have you altered your investment policies? • In what ways have you used the new investment freedoms? • Using internal or external management? • Is there evidence of improved returns? • Any other observations?

8. The Scope of my Talk • The Powers • The Evidence • Some Investment Fundamentals • Freedom with Responsibility

9. The New System – Investment Guidance • Minimal Regulation. • All Councils Treated Equally. • Designed to Promote: • flexibility • responsibility in a prudential environment.

10. The Basic Principles Security Liquidity Yield

11. The Instruments All Instruments with some “exceptions”, such as: • Share & loan capital of corporate bodies are discouraged – safety aspect (pooled products permitted) • Borrowing “purely” to on-lend • Derivatives

12. The Control Regime Investments to be categorised into: • Specified – identified as: • high security/high liquidity • requiring minimal procedural formalities • Non-Specified – seen as: • greater potential risk • requiring a more formalised control regime

13. Specified Investments • Instruments that offer high security & high liquidity: • sterling denominated • maturity of less than 1 year. • Subject to the above: • investments in UK Government, local authorities & parish councils qualify automatically • others must have a “high” credit rating.

14. Non-Specified Investments • All other securities & investments • Each Authority must set out clearly its own guidelines & limits • These requirements form part of the Annual Investment Strategy

15. The Experience Flexibility has enabled active use of: • Long-term deposits (generally up to 5yrs) • Forward fixing (dovetailing with cash flows) • Fuller range of conventional products • Structured products, including: • Callable deposits • Reverse floaters

16. Recent Patterns of Investment Behaviour (1) Key: • A: Cash Deposits, Over 365 Days • B: Money Market Funds • C: Callable Deposits • D: CDs and Gilts Source: CIPFA Treasury Management Benchmarking Club

17. Recent Patterns of Investment Behaviour (2) • A declining use of external managers: Source: CIPFA Treasury Management Benchmarking Club

18. Recent Patterns of Investment Behaviour (3)Source: CIPFA Capital Expenditure and Treasury Management Statistics Series 1994-95 to 2004-05 (£millions)

19. Some Investment Fundamentals The Nature of Investment

20. Local Authority Investment • Any purpose relative to their functions • The prudential management of their financial affairs • Discouragement of speculative investments • Priority to be given to security and liquidity over yield

21. Investment or speculation • A thin line: speculation is the name given to a failed investment and investment is the name given to a successful speculation • The first aim of investment is the preservation of capital while the primary aim of speculation is the enhancement of fortune: “Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money becoming a little” (Fred Schwed, a Wall Street wit) • Economists differentiate gambling and speculation: gambling involves the deliberate creation of new risks for the sake of diversion while speculation involves the assumption of the inevitable risks of the capitalist process • Benjamin Graham, Securities Analyst, argues investment requires a “margin of safety” so that value is maintained even in unforeseen adverse conditions. An uninformed or spontaneous investment is more speculative than one where investor has taken time to investigate and assess returns • Name given to financial uncertainty is ‘risk’ • The more risks are measured and controlled in relation to likely outcomes, the more speculation becomes investment e.g. buying a single share may be speculative, buying a diversified portfolio of shares is an investmentportfolio

22. Measuring and Controlling Investment Risk (i) Define the starting point: • Determine objectives • Look at any liabilities which require matching • Assess cashflow constraints and annual revenue return requirements • Evaluate institutional and regulatory attitude to risk • Consider appropriate investment time horizon

23. Measuring and Controlling Investment Risk (ii) Establish an appropriate benchmark • Representative of neutral, or ‘minimal-risk’ position in relation to investment objectives, e.g.: • if primary objective is to protect original capital sum in ‘money terms’ at all times • choose short-term cash benchmark • A good benchmark should also be: • visible • measurable • investible • But there is no reason why it should not be a ‘composite’ benchmark: • formed from a combination of asset classes with different risk characteristics • which taken together, meet overall investment objectives

24. Measuring and Controlling Investment Risk (iii) • The risk characteristics of different asset classes • Interest rate risk • Credit risk • Liquidity risk • Market risk • The deviation of investment returns from expectations • Volatility (or the standard deviation of historical returns) • Correlation of returns between various assets held by portfolio • Difference between ex-ante (forecast risk) and ex-post (historical volatility) over shorter periods • Random factors including changes in volatility and changes to relationships • Risk premia represent additional return expected by investors over risk-free interest rate (eg UK Treasury Bill to compensate for holding a riskier asset

25. The Risk Return Spectrum – a diagrammatic representation

26. Average annual returns on UK equities, UK gilts and cash deposits (1963-2005) % per year Nominal Return Real Return UK equities 13.0 6.6 Gilts 9.2 2.8 Cash deposits 8.8 2.4 Source: UBS Global Asset Management, 2005

27. The effect of time on equity performance, 1899-2004 Time period (years) 2 3 5 10 18 No. of times equities outperformed cash deposits 69 72 76 89 87 No. of times equities underperformed cash deposits 35 31 25 7 1 Total no. of time periods 104103 101 96 88 Probability equities will outperform cash deposits (%) 66 70 75 93 99

28. Measuring and Controlling Investment Risk (iv) • Active risk, or freedom to depart from the benchmark allocation • Estimated volatility of performance against the benchmark, aka forecast tracking error • Allows understanding of risk/return trade-off being run on a portfolio against its neutral position • Assists with risk budgeting, depending on market opportunities identified • Can demonstrate relative importance of policy and equity/bond stock selection decisions • Portfolios close to benchmark will have low active risk, but portfolios with high active risk will have potential for returns well above benchmark but with a corresponding possibility of substantial underperformance • Pension funds are increasingly measuring their risk relative to liability-driven benchmarks, composed of default-free cashflows (govt bonds), credit-risky cashflows (corporate bonds), inflation-linked cashflows, etc. Derivatives are being used increasingly to adjust risk relative to liabilities

29. Freedom with Responsibility • Cash surpluses have got larger, and more long-term in nature • Investment powers undoubtedly wider • But evidence, anecdotally at least, that motivation for moving up risk spectrum has been low returns: counter-intuitive • If local authorities are to take full advantage of their new freedoms, they must take on the responsibility to understand the fundamentals of investment • This may require a greater emphasis on education and training in the treasury management sphere than has perhaps existed in the past • To quote George Soros, on derivatives: “There are so many of them, and some of them are so esoteric, that the risk involved may not be properly understood even by the most sophisticated investor, and I’m supposed to be one. Some of these instruments appear to be specifically designed to enable institutional investors to take gambles which they would otherwise not be permitted to take”

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