Lee Epstein

Several years ago, Isat in front of ayoung man who

was clearly excited atbeing given theresponsibility to investa sizable working capi-tal portfolio for a midwest healthcare company. During the dis-cussion, he explained his charterfor investing by telling me thathe was a SLY investor. As heexplained SLY further, I listenedattentively, smiling because Iknew where his explanation washeading. I had originated theacronym for an investment classI taught: S = SAFETY, L = LIQ-UIDITY, and Y = YIELD. Beinga SLY investor means that (1)your investments are SAFE,insofar as you select those youbelieve to be free from the riskof default; (2) you make sureyour investments are convertibleinto cash, that they are LIQUID;and (3) you keep on eye on earn-ing a competitive YIELD.

Investing funds belonging toanother party marks a fiduciary.How well do we measure up inthat capacity? Let’s find out bytaking the short quiz in Exhibit 1.

Did you circle youranswers? Okay, let’s review eachquestion in the quiz.

1. HOW DO YOU DECIDE WHICHINVESTMENTS MAY BEINCLUDED IN YOURPORTFOLIO?

Fiduciaries manage invest-ment risks to ensure that thefunds entrusted to their care aremaintained. In that regard, pro-tecting against default is a fidu-ciary’s most important focus.

In the introduction, I usedthe term “working capital.” So,before we continue further, itwill be helpful to define it andanother term, “strategicreserves.” “Working capital”represents monies that may benecessary day-to-day to adjustshortfalls in revenue. Mostoften, these funds are investedusing a buy-and-hold strategy.That is to say, they are investedalmost exclusively for the invest-ment income they generate.While they can be sold, that isnot part of the investment strate-gy. Most often they are helduntil maturity, reinvested to

another maturity, andso on. As the nameimplies, a strategicreserve portfolio repre-sents funds beyondworking capital,although they may be

earmarked for a specific projector purpose. While working capi-tal is usually invested with aneye on coupon income and noprice movement, strategicreserves are, most often, invest-ed for total return (price appreci-ation and income). Accordingly,you wouldn’t want to rely on astrategic reserve portfolio tofund for your first line to makeup a financial deficit.

When you invest workingcapital, you are essentially loan-ing money to an issuer. That’swhy investments classified as“Assets” on your balance sheetare noted as “Liabilities” on thefinancial statements of issuers.So, a credit rating from aNationally RecognizedStatistical Rating Organization(NRSRO) is the preferred mech-anism to translate an issuer’sability to make interest paymentstimely and to repay principalwhen due. (By the way, the termNRSRO comes from TheInvestment Company Act of

Investing funds that belong to another partymeans you have the responsibilities of a fiduciary.That’s a high standard. Take this quiz to see howwell you measure up. © 2000 John Wiley & Sons, Inc.

Investing: What’s Your Fiduciary Rating?

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3© 2000 John Wiley & Sons, Inc.

1940. Curiously, I have neverunderstood the connectionbetween statistics and creditwor-thiness.) Therefore, when pro-tecting against default, it makessense to insist a minimumacceptable credit quality ofissuers the portfolio is exposedto. It is critical that investmentfiduciaries have a sense of therelative creditworthiness repre-sented by AAA/Aaa, AA/Aa,A/A, or BBB/Baa. It is too easy

to default to only issues ratedtriple-A, but doing so may putan investment portfolio at a dis-advantage. Triple-A creditwor-thiness is often overkill and thereare fewer issuers to select from.Consider taking a lesson fromregulated money funds, as theyare required to invest 95 percentof their assets with issuersranked in the “top tier.” Thatrefers to A1 by Standard &Poor’s (S&P) or Prime-1 (P1) by

Moody’s Investor Services(Moody’s) (or equivalent ratings)and translates to A-minus or A3,respectively.

Some investors, especiallythose who have experience incredit analysis, may get involvedin the credit quality decisionprocess. The exercise of individ-ually scrutinizing each invest-ment does nothing to add value.In fact, it usually inhibits theinvestment process, unnecessari-

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1. How do you decide which investments may be included in your portfolio? (More than one answer may apply.)

a) We rely on a minimum credit quality standard as defined by credit ratings issued by nationally recognized statisticalrating organizations (NRSROs).b) We rely on our internal analysis to decide which investments are creditworthy.c) We only purchase investments from our list of approved issuers.d) We restrict ourselves to purchasing (selling) investments from only certain brokers or securities dealers we trust.

2. How do you manage portfolio liquidity?

a) We invest in only very short-term maturities.b) Our investments are restricted to those maturing within one month.c) Our investments are restricted to those maturing within one year.d) We manage the duration of our investment portfolio based on our cash forecast and strategic plan.

3. A compelling argument for using a third-party custodian is:

a) Centralized accounting.b) Competitive offers.c) Reduced exposure to a securities dealer’s bankruptcy.

4. How do you benchmark your investment performance?

a) We compare our performance against T-bills.b) We compare our performance against a money market fund composite.c) We compare our performance against an intermediate bond or note index.d) We don’t benchmark.

Exhibit 1Measure Your Fiduciary Rating

ly reduces the universe of appro-priate investments, and, in doingso, hinders performance. In moreextreme cases, it may put theportfolio in jeopardy and couldbe dangerous—to your career.

On any given day, the num-ber of potential issues of short-term investments offered in themarketplace is overwhelming.That’s why NRSROs first devel-op industry expertise to correctlyjudge the creditworthiness of anissuer. We can illustrate using asimple comparison of two com-panies in separate indus-tries. Assume one is amanufacturing company;the other, we will make anationally recognizedrestaurant chain. When weconsider the cash flow ofthe manufacturing compa-ny, we must consider thestate of its receivables, asmeasured by days outstanding.But when we consider the foodservice company, we find noreceivables, only reservations.You see, NRSROs first develop asystem of industry specific algo-rithms, before they determinecreditworthiness of a specificissuer. Unless you are able tobecome an expert in each indus-try, I suggest you leave creditanalysis to the professionalindustry experts. And yourdependents will be happier, too.Most working capital and strate-gic reserves investments are siz-able. In the extreme, authoringan approved list of issuers couldbe fraught with danger—if anissuer’s credit deteriorates, youcould be held responsible.

There are significant differ-ences between engaging a regis-tered investment adviser andgranting discretion to a broker.Registered investment advisersearn fees for executing theirstrategy on your portfolio. They

realize no revenues from transac-tions. Their services includeshopping for the best execution.Brokers, buying and selling onlythrough their firm’s trading facil-ities, are prohibited by their firmfrom taking advantage of otherdealers’ lower offers (higherbids), and thus are unable to reg-ularly provide best execution.

The only correct answer toquestion number one is a). Everyother option either inhibits per-formance or puts funds (or fidu-ciaries) at risk.

2. HOW DO YOU MANAGEPORTFOLIO LIQUIDITY?

Hopefully, you answered d).Making sure that funds areavailable is a fiduciary’s secondmost important responsibility.The other options fall into thetrap of mistaking that liquidityand maturity are interchange-able. They’re not! Maturityrefers to a date when the issuerpromises to repay principal.Liquidity refers to the ability tomove quickly in or out of a mar-ket, at or near the last purchaseprice. It is related to the numberof participants in that particularmarket, insofar as the more liq-uid a market, the faster andmore easily trades can be exe-cuted at or near specific prices.

Of course, working capitalinvestments should mature with-in the limits of your cash fore-cast. And strategic reserveinvestments should mature with-in the scope of your strategic

plan. Keeping investment matu-rities unreasonably short, for the“sake of liquidity,” usuallyinhibits investment performance.

Dealers should always “bid”on what they “offer.” Which is tosay, if they sold it to you, theyshould be willing to buy it back(at market rates). Given that,maximum settlement is threebusiness days. True, an invest-ment that has a longer maturity,given a normal positive slopingyield curve, usually has greater(price) volatility. But that should

not affect its liquidity.

3. A COMPELLING ARGU-MENT FOR USING ATHIRD-PARTY CUSTODIANIS…

Did you choose c),“Reduced exposure to a

security dealer’s bankruptcy”?But there is no such thing asvendor risk! That is, you do notput the portfolio in harm’s wayby purchasing (selling) invest-ments from one dealer overanother. Supervision of securi-ties dealers, including thoseowned by commercial banks,fall to the National Associationof Securities Dealer (NASD).NASD securities dealers are,like commercial banks,required to maintain adequatenet capital, maintain industrystandard records and custodycontrols on securities held forcustomers. Dealers, like com-mercial banks, are audited reg-ularly by their regulators.

The business of custody canbe broken into two parts. One iseasy and most custodians per-form pretty well; the other partseems to elude them. All custo-dians do a credible job ofexchanging investments formonies or monies for invest-

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© 2000 John Wiley & Sons, Inc.

There are significant differencesbetween engaging a registered invest-ment adviser and granting discretionto a broker.

ments. Most of the investmentsused for working capital andstrategic reserve portfolios aretraded through Depository TrustCorporation (DTC), whichaccounts for more than the $20billion of securities. But,because these investments arearcane, most customers will tellyou that their custodian’saccounting for them ismediocre, at best.

Most complaints cen-ter on a custodian’sinability to properly priceand accrue. For example,you may be familiar withDutch auction preferredstocks. These investmentsqualify for the intercorporatedividend-received deduction,where 70 percent of dividendincome earned by corporateinvestors is excluded from taxa-tion, assuming a minimumholding period. Using a Dutchauction to reset over very shortintervals, these securities areusually issued for intermediateterms for five to ten years.Unfortunately, most custodiansconfuse them with traditionalpreferred stocks or intermediatenotes, and their statementsreflect that. Finding them con-sistently incorrectly classifiedas equities may drive a con-troller loony.

So the correct answer is b).The most compelling reason tohave a third-party custodian isthe additional flexibility it allowsfor additional dealer sales cover-age. By having a centralizeddepository, where any dealer candeliver securities versus pay-ments, you can increase thenumber of dealers that offer yousecurities. And more competitionmeans better offers. When youuse a third-party custodian, inmost cases, you don’t even haveto open an account with the

dealer, simply give them thedelivery instructions.

If you choose to hold secu-rities with your dealers, as an“eligible customer,” you areentitled to protection by theSecurities Investment ProtectionCorporation (SIPC) for eachaccount. Although the SIPC’s

$500,000 maximum insurancemight seem like an irrelevantamount of protection consider-ing the (potential) size of work-ing capital or strategic reserveportfolios, you should recognizethat it applies to any deficien-cies after the return of securitiesand after the pro rata distribu-tion of remaining assets, securi-ties, and cash.

If a SIPC member firm fails,SIPC may seek the appointmentof a trustee to effect liquidationof the firm. First, the appointedtrustee may arrange to havesome or all customer accountstransferred to another SIPC deal-er or customer securities distrib-uted to their rightful owners.Next, eligible customers mayreceive a pro rata portion ofremaining assets. It is importantto recognize that customer prop-erty may not be subject to thegeneral creditor’s lien as part ofthe debtor’s general estate untilall legitimate customer claimshave been satisfied. Any differ-ence between the value of a cus-tomer’s securities, plus their prorata distribution, is supplement-ed by SIPC, to a maximum of$500,000 (including a $100,000

limit for cash claims). However,SIPC coverage does not apply todebt issued by a dealer, such ascommercial paper or repurchaseagreements (repos).

4. HOW DO YOU BENCHMARKYOUR WORKING CAPITAL

INVESTMENTS?

The market earned a6.40 percent last year?Which market? Your portfo-lio earned 6.90 percent forthe same period? So what?Your investment portfoliolegitimately earned 50 basispoints over the market for

the same period. That’s what!As a fiduciary, accepting an

inefficient portfolio, one thateither has too much risk or toolittle return, is inexcusable. And,because if you can’t measure it,you can’t manage it, benchmark-ing is an integral part of invest-ing. A benchmark makes resultsmeaningful. Obviously, thetracking of an appropriatebenchmark will determine thevalidity of all of the benefitsdetailed above.

Properly used, a benchmarkis a convention for comparison,reflecting the investment deci-sions made over an evaluationperiod. Performance depends onthe specific securities and theirchanging value, adjusted for theamount of time they remainedas part of the universe beingmeasured.

Up until recently, a questionon benchmarking a working cap-ital or strategic reserve portfoliowould have been a trick ques-tion. For many working capitalor strategic reserve investors,benchmarking has meant cob-bling together various sources ofinformation, making the requiredadjustments to ensure some

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If a SIPC member firm fails, SIPCmay seek the appointment of atrustee to effect liquidation of thefirm.

comparability, and archiving thedata sources for future reference.This assumes, of course, that theinformation is available.

SOME BENCHMARKING HELP

Well, there is a new alterna-tive, not listed among the possi-ble answers, and you shouldknow about it. Last year, theAssociation for FinancialProfessionals (AFP) introducedtwo new benchmarks. The AFPWorking Capital Benchmark andthe AFP Strategic ReserveBenchmark embody short-term

investment goals, methodologies,etc. Both benchmarks emphasizethe liquidity and credit qualitythese types of portfolios insiston. These tools are available freeof charge on the AFP Web site(www.AFPonline.org), whereusers can see pretax and taxable-equivalent returns. They werecreated to help fiduciaryinvestors measure their portfo-lios’ performance and representa truer standard. Check it out!

In November 2000, the AFPwill premier a subscription serv-ice to allow fiduciaries to cus-tomize the existing benchmarksaccording to individual portfo-

lios, strategies, and so on. Thesecustomizable benchmarks willallow subscribers to adjust mini-mum credit quality, duration,asset selection, and asset alloca-tion to their individual needs andwill report across user-defineddate ranges, thereby giving theinvestor full control over theiranalytical and reporting needs.They will also be accessedthrough the Internet (for anamazingly low $295 annual sub-scription).

So if your fiduciary ratingwas not perfect, there’s a lot youcan do to improve it. And thebest time to begin is right now.

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© 2000 John Wiley & Sons, Inc.

Lee Epstein is CEO of Decision Analytics (San Francisco, California), and the author of a forthcoming bookon corporate investing.