Published in: CUNA Finance Council
ALM First speaks with credit union portfolio managers regularly about investments. Often, we find that institutional portfolio managers spend the bulk of their time evaluating individual securities and developing an opinion on future market movements. At ALM First, we agree with the commonly held view in professional asset management that market timing adds more to portfolio risk than portfolio return. This is particularly true in the high-credit quality sectors that credit unions participate in, as security selection is typically a small contributor to portfolio returns. Rather, long-term performance is a function of duration targeting/management first, sector allocation second, and then individual security selection in a distant third.
Selecting the Right Target Duration for Your Credit Union
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 credit unions 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.
Having a duration target in hand frees credit union portfolio managers from having to form an opinion on the direction of rates and allows them to focus on other tasks, such as researching cross-sector, relative value opportunities and monitoring the risk/return profile of the portfolio relative to its benchmark. Additionally, by having a duration target set, routine reinvestment decisions become relatively simple. For instance, if the portfolio’s duration drifts lower, the investor knows that she should look to add duration on the margin to push the duration back towards the target; and as a result, means that she can narrow her focus to assets with longer durations.