Question: Our financial institution needs a more formalized investment process. What are considered today’s best practices in this area?

It’s vital for an institution to have a well-defined investment process. The best investment decision-making practices are actually timeless. A depository’s investment portfolio serves an important role within the overall balance-sheet management process; and regardless of your portfolio objectives (liquidity, income, etc.), the key goal should be to maximize return per unit of risk taken. For many institutions, those responsible for managing the investment portfolio wear many hats, yet it requires discipline and focus to generate reasonable risk-adjusted returns in fast-changing market, economic, and regulatory environments. Thus, there should be much more to an institution’s investment process than simply looking at bonds.

For many, long-run institutional investing seems a lot like watching paint dry – it’s a little boring and a somewhat routine. But success requires patience and having a sound, research-oriented and well-planned, distinct investment philosophy. In essence, the decision-making methodology used will contribute much more to long-term performance than do individual decisions.

Nonetheless, there are institutions that make many of their investment decisions based on what their brokers show them. Brokers provide a necessary service but, in the end, what they offer are the ingredients to a recipe that has already been developed. Think about managing a two- or three-year duration portfolio for 50 years – you’re making hundreds and hundreds of fairly routine decisions. The decision-making framework or investment process is much more important than any individual decision. To more fully answer your question, let’s look at the process in greater detail.

The Investment Process – A Blueprint for Optimal Portfolio Decision-Making

A good way to think of institutional fixed-income portfolio management is like a “rinse and repeat” process, with portfolio riskiness increased when compensation for risk is high and vice-versa. For example, if yield spreads and expected returns on corporate bonds or mortgage-backed securities (MBS) are low, portfolio weights and exposure to these assets would also be low.

As spreads widen relative to U.S. Treasuries or interest-rate swap rates, exposure is increased. Thus, a data- and research-oriented framework, combined with sound trading level analytical models, equip today’s successful fixed-income managers to address portfolio management in a very controlled manner. Individual security selection can be thought of as the raw materials for portfolio returns. And, as a best practice, consider relative value analysis using robust trading level analysis in an option and credit-adjusted framework.

In Exhibit 1, you can see a portfolio management process that begins with an assessment of the overall balance-sheet risk profile. In particular, the securities portfolio should be managed within an ALM framework, which accounts for the balance sheet’s existing relationship between the asset and liability risk profiles. Arguably most important is interest-rate risk; thus, managing the duration of the portfolio so that the duration of equity is either mitigated or targeted appropriately is very important. However, other considerations, such as liquidity risk, credit risk and earnings needs are involved. Depository investors don’t manage their investment portfolios in a vacuum, making it imperative for the portfolio duration target to be developed in such a framework. After establishing portfolio objectives, it’s important to ensure the guidelines/policy allow for successful implementation of the strategy. If they aren’t aligned, the institution’s portfolio manager is limited in his/her ability to deliver long-term performance goals.

From here, top-down market themes lead the way through the investment process. These themes communicate the current assessment of various market metrics and risk factors that drive sector allocation decisions. Security selection, risk budgeting, and risk measurement bring us to the finish, with ex-post performance evaluation.

At all times, actively managed fixed-income portfolios are at some stage of this feedback loop. For example, we might see monthly top-down themes, combined with daily security selection, weekly risk analysis and monthly performance reporting. Duration targeting and interest-rate risk management take guesswork off the table.

Notice this article doesn’t include a discussion about the direction of rates or when the Fed is going to move. Interest-rate forecasts, rate bets, and trades that are explicitly positioned for a specific interest-rate change have no place in this process and often can cause regrets for portfolio managers. Instead, portfolio performance comes from time-honored risk measurement and management, as well as sector and security selection.

Analytical Models and Why We Need Them Depository investors must have analytical models to identify and measure risks and potential returns. Given today’s dynamic fixed-income markets, the need for robust models increases with the complexity of the assets or asset classes being evaluated.

Exhibit 2 makes the need for robust models clear. The line in the sand is clearly drawn between option and credit embedded assets and their other, simpler, cousins.

The best way to evaluate callable bonds is using a lattice approach while, given the path-dependent nature of the prepayment option, MBS are better evaluated using Monte-Carlo simulations. Interest-rate and option models should price observable market instruments accurately and be arbitrage free, and prepayment models should exhibit a “best data fit” approach. Without these tools, investors cannot properly evaluate market pricing of these assets. Certainly, we don’t want to forget the popular expressions, “model users beware” and “use models at own risk.” Historical examples abound about financial models leading investors to their early demise. Models are only as good as the assumptions that go into them, so it’s vital to invest in the human capital needed to properly manage robust analytical systems. The bottom line is this: Proceed cautiously; understand the inputs and assumptions; and absolutely, positively be critical of outputs. That’s why feedback loops are such an important component of the overall investment process. Models can help us make decisions, but they aren’t the all-important element.

Navigating today’s financial environment is challenging, causing a growing number of institutions to turn to experienced external advisors, both for expert guidance and to outsource specialized functions like investment and balance-sheet advisory. An institutional asset manager can provide the tools and resources (both systems and human capital) needed to build and maintain high-performing bond portfolios at a fraction of what it may cost to attain those resources internally. When seeking outside counsel on investing, institutions must understand how that advisor is compensated (e.g., fee-based or commission), and performance must be measured relative to the stated portfolio objectives. That said, a thoughtful and disciplined investment process should lead to more consistent and predictable earnings from the fixed-income portfolio.

ALM First Financial Advisors, LLC
1Securitizations, Examination Manual,” July 2013, Federal Housing Finance

Robert Perry

Principal at ALM First

Jason Haley

Director, Invesment Management Group at ALM First