Orange County Treasurer Robert L. Citron should have known better. The priority for any manager of public money is to preserve and enhance those funds at reasonable risk. Mr. Citron got his priorities reversed and then compounded his mistake with a high-risk gamble by highly leveraging derivatives and betting on falling interest rates. Responsible use of financial derivatives does have a place in a well-managed portfolio by helping hedge against market uncertainty.
But very real pressure remains - especially as state and local budgets face tight constraints - to stretch contributions to public retirement systems. Yet in Orange County, other types of investments that yield collateral returns in the form of job creation and affordable housing as well as market rates of return are frowned upon as the meddling of do-gooders.
In fact, the uses of financial derivatives and economically targeted investments invite comparison. Both are relatively new financial instruments that can give public system portfolio managers powerful tools for balancing risk, return and benefits to the taxpayer. Used responsibly, they can have an important place in decisions about asset allocation.
ETIs have had their share of problems in sense similar to the Orange County boondoggle. But the common knowledge of bad experiences with public retirement systems in Kansas and Connecticut does not mean that investors should abandon the use of either derivatives or ETIs. Regulators and public policymakers need to establish a framework for their uses. And, investors need to learn more and educate themselves about how these financial products can help them meet their long-term objectives of fund stability and growth.
Most sophisticated investment managers agree that derivatives can be effective instruments for protecting yield in an environment of falling interest rates. The track record of ETIs also shows that they can keep risk down while increasing the return to taxpayers and the community.
ETIs offer risk-adjusted rates of return and invest in jobs and economic development at the community level. Although still controversial, they are catching on among state retirement systems. In Massachusetts, state Treasurer Joe Malone, an innovator in the effective ETI application, has created the American Dream Home Ownership program with $250 million in public pension funds set aside to finance affordable mortgages for first-time home buyers. To date, more than 3,000 families have been able to purchase homes thanks to decreased down payments and more flexible mortgage terms. These bonds are backed by Freddie Mac and have a AAA rating. The added return to the state has been a boost to local home builders and help families become taxpaying homeowners. Massachusetts has also set aside another $25 million allocation for a venture fund targeted to early stage companies in the state.
ETIs also are growing as a tool in the management of public short-term cash accounts where yield is benchmarked to Treasury or certificate of deposit rates. In states like Pennsylvania and Missouri, the state government places public funds in low-risk bank accounts. These funds are then ear-marked for loans to individuals and businesses to start businesses, build houses, train workers and otherwise invest in efforts that boost local economic development.
These ETIs are safe investments, and the return to the community is actually greater than the guaranteed rate of return due to the added benefits created by the financed economic development: the tax base rises and the need for public assistance decreases (not to mention the need for larger government - a popular theme these days).
For example, in rural Nodaway County, Mo., Jason Stoll is one of 3,500 farmers statewide who have used these loans to start up or expand farms.
The application of ETIs and derivatives should be governed by a common five-point framework that ensures they will be used safely and responsibly. These guidelines could be incorporated into legislation or promoted as administrative policy.
First, establish formal investment policies that offer clear goals, policies and priorities. Written policy statements that clarify allowable parameters for investment decisions prevent abuse of the system and protect funds against the unreasonable gambles of investment managers.
Second, promote broad diversification. Olena Berg, assistant secretary of labor for pensions and welfare, argues that "one of ERISA's major principles is prudent diversification that applies to ETIs as well as other investments." Limited investment allocations in the range of 2% to 5% to ETIs and derivatives can have the desired effect of increasing diversification while limiting the potential of any adverse impact. Although more research needs to be done, some initial analysis indicates that ETIs (similar to derivatives) may perform at covariance to portfolio investments, making each prime candidates for diversification.
Third, investment decisions should be open to public scrutiny through public reporting and disclosure requirements. Accountability to plan participants is key to restoring the faith and goodwill of the people who rely on public system to pay the bills of the state or fund their retirement accounts.
Fourth, prudent investment requires some risk that is best managed through regular and formal performance evaluations. A system of checks and balances in which the appropriate public fund and participant representatives review and evaluate performance on a regular basis would create an early warning system for investments gone awry and prevent abuse of the system, as in the case of Orange County for derivatives and Kansas for ETIs.
The lesson is not to limit the investment options of portfolio managers, but to create a framework for making responsible investment decisions. ETIs and financial derivatives are like misunderstood fraternal twins. In some places they have bad reputations, but if used in an educated way within a responsible investment framework, they may have much to offer.
Richard Ferlauto is associate director, the Center for Policy Alternatives, Washington.