Published in: CU Business
In our conversations with clients, we often find that depository portfolio managers spend most of their time looking at individual securities and developing an opinion on which way the market will move. ALM First takes the common view held in professional asset management that market timing adds more to portfolio risk than portfolio return. Additionally, we find that in the high-credit quality sectors that depository institutions participate in, security selection is typically a small contributor to portfolio returns. Instead, long-term performance is a function of duration targeting/management first, sector allocation second, and then individual security selection in a distant third.
Choosing the Right Duration Target
Proper portfolio management starts with getting the duration of the portfolio right. This means aligning the portfolio’s duration with its benchmark, which can be an index such as the ICE BofAML 1-5 Year UST/Agency index. Another option is to benchmark the portfolio to the institution’s liabilities using a liability driven investing (LDI) framework. While more common in the insurance and pension space, this methodology is very much applicable for depositories as well. One benefit of using this framework is that it helps managers keep the entire balance sheet’s risk profile in line by preventing managers from adding too much or not enough duration in the investment portfolio.