Investing excess cash: reducing speculation.

The thin line between investing and speculation is often blurred. Unfortunately, many who are directly responsible for their organization's investments have difficulty in separating speculation from investment. As a result, they may undertake a higher risk with corporate investments than is warranted.

IMPORTANCE OF IDENTIFYING

SPECULATION

This article discusses how to identify and contain speculation. The material is of value to those individuals responsible for investing excess corporate cash. Such individuals include

* Senior treasury management personel. In relying on subordinates to implement an investment program, these individuals sometimes are unaware of inappropriate investment strategies.

* Cash or treasury management personel who execute the investment transactions. Without specific guidance, these individuals could make decisions that management deems too speculative.

* Auditors (internal or external). Because the individuals responsible for monitoring a corporation's financial activities usually are not experts in investment strategy, they could have difficulty recognizing potential or existing investment problems until it is too late.

Since investing is subjective, an organization first must develop standards to distinguish between investment and speculation. These standards then must be used to put together a statement of investment policy and guidelines which define a prudent investment program designed to avoid investment risk. Investment activities that fall outside the guidelines should be considered unacceptable.

TYPES OF RISK

Here is a brief discussion of some major investment risks.

* Credit or default risk, simply stated, is the possibility that the investor's principal and/or interest will not be returned when due. Speculation occurs when instruments with low credit ratings or high default risks are purchased to obtain higher yields.

* Market or interest rate risk refers to the possible decline in the market value of fixed-income securities if interest rates rise. The longer the maturity on the instrument, the more prices are affected by interest-rate changes. A speculator may purchase a longer maturity solely for the potential price increase if interest rates decline. This price increase potential encourages speculation in long-term, interest-bearing securities.

* Liquidity risk refers to the inability to convert an instrument to cash, with little or no penalty for the conversion. (Instruments that can be readily sold are highly liquid instruments.) However, instruments that provide little or no liquidity generally carry a higher rate of return to reward the investor since they cannot be converted quickly to cash. A speculator who seeks out these instruments for the higher yield might not consider the risk of illiquidity.

RISK CONTAINMENT 

The following paragraphs outline elements that should be included in forming an investment policy to reduce speculation.

* Investment committee. A group of senior management, perhaps members of the board of directors, should be formed to address management's investment goals.

* Policy statement. A policy statement may be a brief declaration of management's attitude toward risk versus reward. It should address whether or not the organization desires funds exposed to greater risk to capture additional yields. For example, a policy statement might read, "The investment objectives of Organization X, in order of their importance, shall be safety of principal, liquidity and a competitive rate of return."

* Investment responsibility. Individuals responsible for executing investments and maintaining all related documentation should be authorized by title in the investment guidelines. Furthermore, at least two individuals should be given this authority to ensure that one is available at all times.

* Types of investments. Instruments authorized for investment should be described thoroughly. It is not adequate to say U.S. government agency securities are an acceptable investment. Rather, the guidelines must specify which government agencies are acceptable. If bank obligations are authorized, the guidelines also must require a minimum size for the bank, based on deposit size and a minimum acceptable credit-quality rating.

Most speculative programs include instruments of longer maturity, generally over several years. Furthermore, the instruments may be unusual, such as less commonly traded U.S. government agency securities, smaller-sized bank obligations or low credit-rated corporate investment vehicles. The sidebar on page 95 contains a list of highly speculative instruments often found in portfolios.

* Credit ratings. Investment guidelines should contain minimum credit-quality rating requirements. Credit-quality ratings usually can be assessed by retaining a credit review service, which, for a fee, will provide the investor with credit ratings analyzing the safety of invested dollars. Credit review services that provide credit ratings to investors include, but are not limited to, the following:

Moody's investors Service 

[phone]

Standard and Poor's Corporation

[phone]

Thompson BankWatch

[phone]

However, these services are not infallible and should be used only as a guide.

* Limitation of maturity. To address the problems of interest rate (market risk) and liquidity risk, the guidelines must establish a maximum maturity. For instance, if the organization has ongoing needs for funds, then maturities exceeding 90 days might not be appropriate. But, if the needs are less immediate, maturities of one through five years in liquid (marketable) securities might be acceptable. The use of longer securities should be strictly monitored to reduce the possibility of speculation on the future movement of interest rates.

* Reporting. Timely report must be provided

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to individuals who oversee the investment function (management, accounting and the treasury staff). Guidelines should outline which items should be covered by the reports and the frequency of their distribution. Auditors should be satisfied that the reports are verified with independent sources (banking records, custodian asset lists) and accurately represent the firm's investment activity.

* Safekeeping account. An account should be established at a bank with a good credit rating to serve as a "delivery versus payment" custodian for the securities in the investment portfolio. With this arrangement, the purchased instrument is paid for with investors' funds in a pre-assigned bank account. The custodian then holds the security, collects interest and tenders it for payment at maturity. This arrangement also facilitates audit and recordkeeping procedures and helps to assure that purchased instruments actually are delivered and are paid for only at delivery time.

BEING AWARE

The elements of a sound investment program are intended to alert those whose responsibilities involve investing. Being aware of the risks associated with investing, as well as knowing how to spot risks and contain them, should help finance professionals to be more productive and efficient in their responsibilities.

ALAN G. SEIDNER, president of Alan Seidner & Company, an investment management and consulting firm in Pasadena, California, is a frequent author and lecturer on investing and related financial subjects. He has written Corporate Investments Manual: Short and Intermediate Term Fixed Income Securities (Warren Gorham & Lamont Publishers, January 1989) and coauthored with William O. Cleverly Cash and Investment Management for the Healthcare Industry (Aspen Publishing, November 1989).