Selection and Review of Investment Advisors

Any public finance official who has worked in the industry prior to 2007 understands the importance of investments and their potential for generating returns while providing for safety and liquidity. Before the financial crisis of 2008, governments often balanced yield with risk to maximize returns within these parameters. However, post-2008, the economic context changed dramatically. Interest rates fell to historic lows and remained at the floor for a significant period. For many years, earning even fifty basis points on investments was seen as a good return, especially during prolonged periods of near-zero rates.

This environment persisted until after the COVID-19 pandemic, when a rapid shift in monetary policy fundamentally altered the investment landscape. Starting in the spring of 2022, the Federal Reserve began a series of aggressive rate hikes, causing the short end of the yield curve to rise significantly. By late 2024, rates had reached their highest levels in decades. Although rates have declined somewhat from those peaks, governments still have the opportunity to generate significant returns by strategically managing their investment portfolios.

For larger governments with the resources to manage investments in-house, direct purchases of U.S. Treasuries and federal agency securities may be feasible. However, the majority of government entities either rely on state-managed pooled investment funds or hire an external investment advisor to assist with portfolio management. Deciding whether to hire an investment advisor is a critical step, and governments should carefully assess their readiness and establish a strong foundation before proceeding.

Foundational Elements for Investment Programs

Before engaging an investment advisor, governments must ensure they have the following critical elements in place:

1. Cash Flow Analysis

Understanding cash flow is essential for managing a portfolio effectively. Governments need to account for the timing of major inflows and outflows, such as tax revenues, grant receipts, debt service payments, and payroll obligations. A clear understanding of cash flow helps determine how much of the portfolio can be allocated to longer-term investments versus what must remain liquid. A failure to align investments with cash flow needs can jeopardize the liquidity of the portfolio, leading to unnecessary borrowing or the forced liquidation of investments at inopportune times.

2. Investment Policy

A well-drafted investment policy is the cornerstone of a government’s investment program. This policy provides the guidelines for how funds will be invested, establishes allowable investment types, and outlines risk tolerances. It also ensures compliance with state and local laws governing public funds. A strong policy will emphasize safety and liquidity while allowing for diversification to manage interest rate and credit risks. For governments that do not have an investment policy in place, creating one should be the first step before considering any investments.

3. Interest-Earning Implications

Governments must understand the implications of interest earnings, especially when managing bond proceeds or other restricted funds. For instance, arbitrage calculations can create risks if returns on invested bond proceeds exceed the allowed thresholds. Being proactive in understanding these dynamics is critical to avoiding costly compliance issues.

Establishing an investment program without fully addressing these foundational elements is risky and can result in liquidity crises, excessive risk exposure, or violations of statutory or policy guidelines. A robust investment program begins with cash flow analysis and a comprehensive investment policy that prioritizes safety and liquidity while allowing for prudent returns.

The Role of Investment Advisors

The Government Finance Officers Association (GFOA) recommends that state and local governments exercise caution and prudence when selecting investment advisors. While an advisor can provide valuable expertise, the fiduciary responsibility for safeguarding government funds cannot be delegated. This means that government officials must work closely with the advisor to ensure alignment with investment policies and objectives. Below are practical insights for implementing a sound investment advisor selection process:

a. Understand the Service

Before hiring an advisor, governments must decide whether they will utilize a non-discretionary or discretionary agreement. Under a non-discretionary agreement, the advisor provides recommendations but must obtain approval from government officials before executing trades. In a discretionary agreement, the advisor has the authority to execute trades without prior approval, provided they adhere to the investment policy. Understanding which structure best suits the organization’s needs is critical to setting expectations and defining responsibilities.

b. Prioritize Transparency in the Selection Process

A transparent and competitive procurement process is essential to selecting a qualified investment advisor. Governments should issue a Request for Proposal (RFP) to gather detailed information on potential advisors, including their SEC licenses, organizational structure, reporting capabilities, experience with public funds, and investment philosophy. The RFP process not only ensures competition but also provides an opportunity to assess fees and service levels. Shortlist candidates based on the RFP responses and conduct interviews with finalists to evaluate their approach and key personnel.

c. Verify Experience

It is vital to ensure the investment advisor has experience managing government funds and navigating the specific regulatory and policy constraints that apply to public entities. Checking references and reviewing the advisor’s track record can help confirm their qualifications.

 d. Define Clear Performance Metrics

Establishing clear performance metrics is crucial for evaluating an advisor’s effectiveness. Metrics should align with the investment policy and include benchmarks for returns (e.g., comparing portfolio performance to the 90-day Treasury bill rate) and risk limits to prevent concentration in specific asset classes.

e. Negotiate a Fee Structure

Governments should carefully negotiate fee structures to ensure cost-effectiveness. Options include flat annual fees or fees based on the portfolio’s size (e.g., a certain number of basis points). Consider the long-term impact of fees and ensure transparency in all costs.

f. Maintain Regular Meetings

Frequent communication with the investment advisor is necessary to align the portfolio with cash flow projections and market conditions. Monthly or quarterly check-ins allow adjustments and ensure the advisor meets performance expectations.

g. Review the Policy Annually

Investment policies should be reviewed annually with the advisor to ensure they remain relevant in light of market changes, legal updates, or organizational priorities. A well-maintained policy enhances the program’s effectiveness and ensures continued compliance.

h. Establish a Trust Account

Setting up a trust account with a bank for managing investments can be a practical option. A trust account provides segregation of funds, custodial oversight, streamlined transaction processes, enhanced reporting, and improved liquidity management. This setup can add security and efficiency to the investment program, especially for governments that rely on external advisors.

Final Thoughts

Adopting the GFOA’s guidelines for selecting and reviewing investment advisors is essential for implementing sound investment practices that protect public funds and enhance returns. A successful investment program requires a proactive and strategic approach, with strong foundational elements such as cash flow analysis and a comprehensive investment policy. Governments must exercise diligence in selecting advisors, ensuring they are qualified, experienced, and aligned with the organization’s goals.

Public finance officials must embrace their role as stewards of taxpayer dollars, recognizing that every decision made in the investment process carries implications for their community’s financial health. A carefully coordinated, transparent, and disciplined approach to managing investments will yield financial benefits and build confidence among stakeholders in the government’s commitment to fiscal responsibility and long-term sustainability.