So it was with the Moving Wave Theory of Investment Planning.
Not that I'm in love with the name, but we needed one and it stuck.
The Moving Wave came out of a sudden need and opportunity. You see, at the City we had just lost our Investment Officer. She'd been in the role for more than 30 years and had made it her own.
The issue was that the Finance Director; essentially the CFO of an organization serving 250,000 citizens, with revenues of $305 million, and assets of $3 billion; was unwilling to allow the investment portfolio to extend any significant length of time. And by "significant", he meant more than one or two months. As he put it, he wasn't able to trust that we'd have cash on hand when it came time to pay the bills. I know it sounds surprising.
About that time, he asked me to take over as Investment Officer. So I became the steward of a portfolio of $200+ million, mostly in Corporate Paper, Agencies, Corporate Notes, and US Treasuries. My having to answer questions from Denver Post and Rocky Mountain News about the recent collapse of Orange County California notwithstanding, we had a pretty safe portfolio.
The problem was that the portfolio had an average duration (as I recall) of around 22 days and as a result, the returns are much weaker than they could have been. At that time at least, extending the portfolio could yield several hundred additional basis points, but the Finance Director wouldn't have it. The risk of failing to meet a debt service payment or having to rapidly liquidate a security, unplanned, was too great.
In the City, we collected essentially one-twelfth of our annual revenue each month, mostly from sales and use tax. We got other revenues from time-to-time (property tax) but the lion's share was sales and use tax. This means that, like most household budgets, we got new cash by the end of each month. County governments, for example, are are on an entirely different schedule. Because they rely on Property Tax mostly, they get new cash twice a year.
The solution to give him confidence, came not from the finance world, but from manufacturing.You see, there is a tremendous cost to a production line if inventory isn't available when it is needed. If a "widget" reaches Assembly Point X and finds no "therbligs" to be attached to its side (or top, or underside, or whatever), the line shuts down and widgets don't get made. Widgets, being exceptionally profitable, must keep rolling off the line!
To ensure this doesn't happen, several forms of "safety stock" calculations exist, starting with the simplest form, basically, "when the pile of therbligs drops below this line on the bin, order more."
The same principle was true here. If cash wasn't available on such-and-such a date to make an important payment, heads would roll. So we created a cash-based safety stock process and called it The Moving Wave.
Here are the basics.
First, figure out the revenue cycle. In our case, it was monthly.
Second, multiply it by three. We did this based on a strategically chosen level of risk. Three months became the duration of the "Wave". In a County, it would have been 18 months. We could have made it 4-times, but the risk-reward balance would have been out of whack.
Third, mine the accounts, debt service schedules, payroll records, and budgets of the entire organization and identify *all* cash outflows. Then set up specific relationships with key individuals in each of these areas so you can feel comfortable that if someone generates a new cash payout obligation in the future, you'll know about it.
Four, create a schedule of the maturity dates of every security you currently own and overlay it on the outflow schedule.
Five, when any cash comes in (either new or from a maturing security), invest it so that it matures one day before the cash outflow obligation is due. Each expected outflow for three months from the current day is considered a "hole" in the "wave." When all holes are filled, you are authorized to invest in securities with durations greater than the length of the wave. Tomorrow the wave rolls one day forward and we look to ensure that all holes remain filled.
The result of this approach is to quickly extend the portfolio's average duration to something greater than 30 days, and to provide opportunities for investment with much longer durations. At the City, by the time we'd completed a full year, we were able to invest out to about 3 years. The portfolio's average duration grew to three months and then longer and our returns went up.
There was a great deal more analysis that went into understanding the behavior of the wave, such as examing the cost-benefit of filling a hole 2.5 months in the future at one rate versus another hole closer in time at another, but you get the picture.
While driving returns up was important, more important was the ability to show the Finance Director a single spreadsheet, with all the holes filled to the leading edge of the wave, and give him confidence.
It was also a happy outcome that two major regional governmental groups (GFOA- Governmental Finance Officers Association and DRCOG- Denver Regional Council of Government) found the concept so exciting that they, along with the City itself, gave it awards.
-- Prescott Coleman, CIA, CISA
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