How to optimize the return of your credit union’s investment portfolio: Part 2, creating an investment plan

In my first CUInsight article in a series on managing credit union investment portfolios (March, 2015), I summarized the benefits and basic steps in skillfully managing your credit union’s investment portfolio, which are as follows:

  1. Create a plan (e.g., draft a good investment policy);
  2. Execute the plan (e.g., buy the right securities at the right price and sell the wrong securities at the right price);
  3. Monitor the portfolio on an ongoing basis (e.g., keep an eye on the credit, liquidity and interest rate risk of the securities in the portfolio);

In this second article of the series, I’ll review the first step; creating an investment plan, the most important part of which is drafting an investment policy.

The law requires federal credit unions to have investment policies. 12 CFR 703.3, which is part of the “Investment and Deposit Activities” section of the regulations governing federal credit unions, reads in relevant part, “A Federal credit union’s board of directors must establish written investment policies consistent with the Act, this part, and other applicable laws and regulations and must review the policy at least annually.” Drafting an investment policy is a balancing act. It must include at least basic obligations and limitations (as listed in 12 CFR 703.3) but not too many more than that. Why? Because, as stated in my previous article, examiners often look to determine whether your credit union really follows its own investment policy – all of it. If you don’t follow every provision of the policy, whether in the purchase of securities, monitoring of them or any other provision, expect to the examiners to ask for an explanation, regardless of whether your credit union is legally obligated to do it. So, if you include a provision in the policy obligating your CU to do something (or to refrain from doing something), you’re expected to comply with it. In effect, when writing an investment policy, you’re creating your own law and the cops (examiners) will police it even if the regulations don’t require you to include a given provision in the policy. And this phenomenon applies to all policies – not just investment policies. So, your goal here should be to write a Goldilocks investment policy – not too hard, not too soft, but just right.

Certainly an important part of any investment policy is the objective of the investment portfolio, which in theory is simple: get the portfolio to return an amount that is greater than the cost of acquiring the funds in the portfolio. Easy enough on paper. But optimizing (as distinguished from maximizing) the return of your CU’s investment portfolio must done within the parameters of your CU’s asset-liability management (“ALM”) obligations, not just a reach for high returns, particularly while we wait for interest rates to inevitably rise, which will in turn adversely affect the price of bonds. Since the investment portfolio is made up of the extra liquidity of the CU (e.g., the money that isn’t loaned out), a CU must be mindful of its liquidity needs by keeping an appropriate portion of the funds in the investment portfolio quickly accessible and easily convertible to cash. This should an important part of a CU’s ALM tactics (short-terms plans) and strategy (long-term plans) and should be expressed in the investment policy.

The basic terms of your CU’s investment policy must cover the following items per 12 CFR 703.3:

  • The purpose/objectives of the CU’s investments
  • Characteristics of the permissible investments (e.g., issuers, maturities, call provisions, average life, etc.)
  • How the CU will manage risk, including:
    • interest rate risk (“IRR”)
    • liquidity risk (as briefly explained above)
    • concentration risk (e.g., a lack of diversity among issuers, geography, maturities, etc.)
  • Identifying who has authority to make investment decisions, with the understanding (per the regulations) that “Those with authority must be qualified by education or experience to assess the risk characteristics of investments and investment transactions.”
  • Identifying the broker-dealers and safekeepers the CU may use
  • How the CU will address a security that, after its purchase, falls outside of policy or otherwise fails a requirement of the regulations
  • How the CU will conduct trading activities, including the following:
    • Who has buy/sell authority
    • Account size trading limits
    • Cash flow allocation
    • Stop loss or sale
    • Limits on type, quantity and maturity
    • Time limits on holding securities; and
    • Internal controls, like segregation of duties.

Those are the elements of a good investment policy; not too hard, not too soft, but just right. But planning is relatively easy. Execution is tougher. So, in my next article, I’ll summarize how to execute the investment plan and optimize its return within the context of a CU’s overall asset-liability management environment. Because, as the great German writer and statesman Johann Wolfgang von Goethe wrote, “A really great talent finds its happiness in execution.”

David Barnes

David Barnes

Mr. Barnes, a licensed attorney and registered investment advisor representative (Series 65), leads the Heber Fuger Wendin team in service to their institutional and individual clients. He became a Heber ... Web: Details