Managing Your Portfolio: When Should You Outsource?

Oct 15th - Dwight Johnston, VP of Economic and Market Research, WesCorp
October 14, 2004

For certain credit unions, the contribution to earnings from investments is still an insignificant portion of total income, and the lack of attention to investments may be understandable. But many credit unions have not faced the fact that the investment portfolio is now an important piece of the overall earnings picture. By ignoring this growing sector of the balance sheet, credit unions are missing opportunities to improve earnings and provide a stable source of income that will improve reserves and facilitate future growth. Consider the following suggestions, based on the size of the institution.

Assets Less than $100 Million

At many small credit unions, the role of investment manager usually falls to the CEO or CFO. The time allotted to investment decisions may be literally just a few minutes a week. If the investment portfolio now represents 25% or more of total assets, earnings from that asset base can be beneficial in covering operating costs. The costs of hiring an investment professional or paying for the services of an investment advisor can be prohibitive for smaller credit unions.

If, as the CEO or CFO, this task falls to you, first consider seeking additional sources of education. This can come from attendance at investment seminars such as those provided by your corporate or another valued source, webcasts, or training courses. The second consideration, for those that invest in securities, is to use more than one broker and perform the necessary due diligence on that broker's firm.

Third, consider utilizing a laddered portfolio strategy using fixed-rate, fixed-term bullet investments. The laddered portfolio strategy has several advantages. It provides the part-time investment manager with a simple, quick decision-making process. As investments come due, the proceeds are simply reinvested at the end of the ladder. The ladder also means that the credit union will have investments coming due in all interest-rate environments. There will be no need for market timing decisions.

A portfolio composed primarily of callables and mortgage products has the unfortunate characteristic of returning funds at just the wrong time in the interest-rate cycle. Lastly, a laddered portfolio will far outperform returns from just riding short-term rates except in those rare times of inverted yield curves.

Assets from $100-$250 Million

For medium-size credit unions, investments are frequently handled much in the same manner as in smaller credit unions but the rewards can be even greater for improved portfolio performance. The options to improve performance also are much the same, but there is an additional resource a medium-sized credit union can consider. That option is the use of a registered investment adviser.

As an example, fees for an investment adviser for a portfolio of $100 million are roughly ten basis points or possibly less. Compare that to the costs of hiring an in-house investment expert. That can easily cost $150,000 when salary, benefits, and costs of investment information systems are included. While the cost of an investment adviser is still a hurdle for a credit union to overcome, consider that a good investment adviser should be able to improve portfolio performance by twenty basis points or more by dedicating a portion of the portfolio to higher-yielding structured products and by providing advice on the overall structure of the portfolio. That could mean an additional $100,000 net to the bottom line.

Assets More than $250 Million

For larger credit unions with investable assets of $250 million or more, a more active approach to portfolio management employing a portion of the funds in more complex securities can produce superior performance. For those larger credit unions, it is easier to justify a dedicated in-house investment manager. But getting the right person on board can still prove difficult, as could succession planning when the individual leaves.

Many larger credit unions do opt to use an investment advisor for these very reasons. One other key reason for outsourcing this function is the variability of costs associated. Fees for investment advisory services are generally contracted based on investable funds (i.e., if loan demand does escalate and investments shrink, the fee paid also will be lower). If you have a full-time investment manager and investable funds shrink, you will be faced with a much more difficult decision regarding the expenses of that position.

Final Considerations

Realistically assess your liquidity needs. Many credit unions continue to overestimate their liquidity needs. The biggest performance drag on investments is typically having too much in overnight funds or especially short investments.

Consider this: In May 2002 fed funds were yielding 1.75% and a two-year certificate yield was 3.6%. For a credit union with $5 million in excess liquidity, a break-even analysis comparison of how high and how quickly the rate on fed funds would have to rise during the two-year period would have shown that the two-year certificate was a reasonable choice. Absent the knowledge and resources to complete this analysis, a credit union likely would not have recognized this and may have remained invested in fed funds.

During the following two years, the $5-million excess liquidity left in fed funds produced a total income of $125,000. Income from the two-year certificate was $360,000. Of course overall accurate balance sheet risk assessment is critical while pursing any portfolio strategy.

Although your credit union may fit the description of having an under-performing investment portfolio, your options might be limited if you hold significant amounts of mortgages.

Johnston can be reached at djohnston@wescorp.org.