Cash & Liquidity ManagementCash ManagementPracticeInvestment Portfolio Management and Alternative Approaches

Investment Portfolio Management and Alternative Approaches

Corporate organisations naturally divide into those which are leveraged to at least some degree and in a ‘net borrowed’ consolidated position and those carrying surplus liquidity, which in theory may be invested over a wide maturity and investment instrument spectrum.

Recent historically-low interest rates mean that cash and short-term investments do not generate attractive income yields for companies. At the same time, the global economy provides an increasingly attractive range of business investment opportunities as regions recover from recession; so there are commercial incentives to deploy surplus cash in developing the core business. There are also natural market-based incentives, especially for publicly-held companies, for surplus cash to be distributed to shareholders, or used for equity buy-backs, to avoid potential share price depression. Nonetheless, many corporates are presently cash rich.

The credit crunch after the 2008 financial crisis led to significant changes in treasury policy and practice. One common corporate response was to accumulate substantial cash reserves and invest in instruments with high levels of liquidity and creditworthiness; yield was not a primary consideration. Currently, many corporations retain substantial cash and near cash reserves in short-term portfolios.

Historically there have been many other scenarios. It was once common practice for larger corporations to operate a dynamically-managed long-term investment portfolio in an attempt to increase revenue and profits, especially when the core business was stagnating or suffering squeezed margins from effective business competition. The underlying objective of establishing and managing the investment portfolio was to enhance the corporation’s competitive performance, at least against its industry peer group.

Today, such ‘profit centre’ treasuries are out of favour except among a few exceptional and large corporations, since the costs, risks and results have discouraged the establishment of similar enterprises. Additionally, the practical realities of legal and taxation regimes may restrict or effectively eliminate the operation of long-term portfolios as a viable option.

Short-term versus Long-term Investment Horizons

Most corporate investment portfolios operate with a short-term maturity profile, placing surplus cash in approved investments. Maturities coincide with known cash demands, such as cyclical invoice payments, interest, dividend and royalty obligations, and operating costs such as payroll and rents. The instruments used are typically time deposits and money market fund (MMF) investments, sometimes foreign exchange (FX) swaps and purchases of short-term money market instruments.

TMSs generally support this common type of operation via the deal workflow functions described in ‘Treasury Dealing and Hedging.’ In summary, the TMS scheduling and reporting functionality alerts the investment dealer to upcoming investment maturities and the organisation’s cash demands, to support rollover and new investment activities with residual cash surpluses.

There are several reasons why some companies presently run-long term investment portfolios. Finance policy may require that committed longer term liabilities are hedged with a matched portfolio of investments. Alternatively, a fully dependable liquidity reserve may be operated as insurance against future deterioration in the corporation’s creditworthiness. Also, there may be tax and interest rate arbitrages available that are implemented by borrowing in one market or regime, and investing in another. In all cases, the tax and legal requirements may work for one corporation’s situation/financial risk policy but not for others.

The Technology Choice

For those corporate treasuries operating a financial investment portfolio, there are numerous issues surrounding the selection and deployment of the supporting technology – especially for an actively managed portfolio. Classic TMSs are today engineered around treasury transactions and their cash flows. They work under the fundamental assumption that an investment has been purchased with the intention to hold until maturity. They may also not provide intuitive support for calculations such as interest accruals on bonds and certificates of deposit (CDs) dealt in the secondary markets. Active portfolio management can therefore stress ‘standard’ TMS functionality, to the extent that users may have to accept a degree of compromise between their ideal solutions and practical, cost- effective corporate reality.

A further technical complication originates from the investment portfolio concept of ‘position ’-another phenomenon not particularly well managed by TMSs. A position may be accumulated through several purchases of the same investment instrument and their subsequent consolidation. The practical situation is further complicated when the position is adjusted by any sale prior to maturity that results from applying risk management decisions. Some TMSs may not co-exist happily with these concepts; for example in maintaining an accurate average price for the position. Additionally, many TMSs do not include support for intuitive investment instrument sale transaction types, making management of any pre-maturity disposal potentially messy through the need for ‘work around’ solutions. Further, the analysis and reporting of investment positions can be surprisingly demanding for some TMSs, for technical reasons relating to database structure.

These factors carry implications for the accounting treatment required, which markedly differ from the cash and accrual accounting generally found in corporate treasury. Actively managed investment portfolios use accounting approaches such as ‘first-in, first-out’ (FIFO), ‘last-in, first-out’ (LIFO) and average rate/price. The first two methods require tracking of the component trades of a position (‘lots’), with the added complication that arises when sales of parts of lots are transacted in the course of portfolio management operations.

Outsourcing Investment Management

The optimum technology to support a company depends on the cost/benefit analysis of the risks and operational costs of running the portfolio in-house versus external alternatives. A solution issue is typically found by outsourcing the operation to specialist fund managers. In this case, the manager’s reporting system can be interfaced to the TMS, for central visibility of the cash and risks that are being managed.

In-house Alternatives

If the portfolio is managed in-house, the appropriate technology solution is again determined by the underlying scope and complexity of the requirement. An important factor in the assessment of the required solution scope is the breadth of instrument coverage needed. Most TMSs accommodate fixed and floating rate corporate and government bond investments and corporate treasury standard derivatives such as interest rate swaps, but the use of equities and more exotic derivatives may be outside the system’s capabilities. The number of investment positions and the degree of active portfolio management practiced are further important solution and budget evaluation factors.

In contrast to the potential long-term investment portfolio management shortfalls of many TMS solutions, corporations requiring mission-specific functionality need to consider the costs and benefits of deploying a specialist solution. Investment management systems, designed for funds management organisations, do not come cheaply and many companies must settle for a TMS solution for budgetary reasons. Specialist solutions address active management requirements, investment accounting and other specific issues described above, and they additionally offer in-built risk management features such as internal rate of return and value at risk derivation, benchmarking and portfolio simulations. Such solutions have very different technical architecture compared with TMSs, reflecting different functional demands and complexities.

One area where the TMS provides full support is in consolidated counterparty exposure management. Bond and equity investments require limit allocation and management and integration with counterparty exposure analysis for the same reasons as apply to short-term exposures such as bank account balances, time deposits and investments in money market instruments. This highlights the general need that a truly effective counterparty risk management solution should encompass all classes of exposure.

Other benefits of using a TMS solution include the use of consistent TMS deal management workflows, with integrated cash management and visibility.

TMS Evolution Possibilities

The present and practical reason why TMS long-term investment management functionality is rarely well-developed stems from a general lack of heavy demand for support for this kind of business. As noted earlier, this hasn’t always been the case. Presently, companies needing powerful solutions in this area face complex selection projects and potentially significant licensing and implementation costs to achieve functionally uncompromised success. There will need to be a significant shift in demand patterns to stimulate sustained action from TMS product managers to evolve the required solutions in this particular area.

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