Annexe 1
Review of Treasury Management Arrangements for
Epsom & Ewell Borough Council January 2002
Summary
The following report contains a detailed review of the investment activity and
performance of Epsom & Ewell’s two external fund managers – Investec Asset
Management and Merrill Lynch Investment Managers. It covers the last three full
financial years in which the two companies operated – 1998/99 to 2000/01. This
ensured each manager’s behaviour and results could be assessed over a complete
interest rate cycle. We have excluded the part-financial year to December 2001 on
grounds that the results are incomplete and could still alter substantially before year
end, given the current volatility of the financial markets. That said, there has been not
any significant change in the ‘normal’ behavioural patterns of either manager in the
past three quarters.
In order to provide a balanced view of the past, the analysis is conducted from a
number of different angles. Investment activity in the gilt-edged and money markets
is studied in each of the three years in the context of developments in the domestic
and international economies. This background plays an important role in determining
whether the optimum allocation of assets was undertaken at different points of time.
Aside from the timing of decisions, the report throws light upon the extent to which
the managers utilised their permitted investment parameters and whether the full
range and percentage proportions of allowable instruments was used. The key
consideration in this respect was the extent and frequency of activity in the gilt-edged
market, where the managers were assigned different limits as to the maximum
percentage that could be held at any one time – 50% of the total portfolio value in the
case of Investec and 25% for Merrill Lynch.
Investment activity and market developments provide the backdrop against which
performances can be assessed. Each manager’s net returns have been compared
with the 7-day deposit rate benchmark and the weighted average achieved by as
many as possible of the companies involved in the management of local authority
‘capital preservation’ funds. To this extent we conducted an exercise the see whether
the restriction of Merrill Lynch to stricter investment parameters than is standard for
these funds had any tangible effect upon asset allocation or performances. Our
findings in both cases was that it did not. Consequently, the performance tests we
have conducted are as equally relevant for Merrills as for Investec.
As far as the market background was concerned, conditions since 1998 have been
far from stable. Financial markets were subjected to some of the most substantial
swings in fortunes seen in the second half of the 20th Century. Violent movements in
equity markets, the collapse of prominent financial organisations (such as Long Term
Capital Management), the Russian debt default and Asian financial crises promoted
a number of developments. The most significant of these as far as the Council’s
investment funds were concerned were the increased volatility of the money and giltedged markets and the downward trend in interest rates to levels not seen since the
very early 1960s. Market volatility does present dangers to the unwary, but with
adequate risk management procedures, it can be turned to advantage and used to
boost overall returns.
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Annexe 1
Both of the authority’s fund managers adopted an active approach towards
investment in the money market. The full range of the yield curve was utilised and
assets were allocated to different maturities in accordance with their views on the
value available and the prospects for interest rates.
Where the managers differed most markedly was in their approach to the gilt-edged
market. This was noticeable in two respects. First, the extent to which each manager
made use of their permitted investment parameters. Secondly, the overall style of
investment.
Investec was the most active and enthusiastic user of the gilt-edged market by a very
wide margin, relative not only to Merrills but also to all other managers. On occasions
when its analysis suggested this asset class provided opportunities for substantial
returns, the manager would invest close to its permitted maximum. This took place
on two occasions during the period of the review, both with positive consequences
for performance. In addition to this, the vast bulk of gilt-edged purchases was
undertaken as part of a strategic investment approach. In other words, the manager
purchased these securities with the intention of holding them to take advantage of
relatively large movements in yields. This usually meant the securities would remain
in the portfolio for a number of months.
Merrill Lynch, on the other hand, adopted a more cautious approach to this market.
On no occasion did the allocation of assets to gilts get close to the maximum
permitted level. In addition to this, the investment style was different. On most
occasions, the manager adopted a tactical approach whereby securities were
purchased with the intention of taking advantage of comparatively small price
changes before being sold. This meant that securities were normally held only for a
matter of weeks or days. Many of these deals proved to be profitable (especially in
the earlier part of the review period), but there were a number of failures.
There is nothing wrong with either style of management and in some respects it can
be a useful source of risk control. But it did account for a relatively large proportion of
the difference between the performance of the two managers. Merrill's temerity
towards the use of gilts did mean that it missed out on a number of good
opportunities or that it was not correctly positioned at the outset of the few notable
rallies to reap significant rewards. Of course, there were times when caution paid off
and the portfolio did not suffer the consequences of falling gilt prices – notably in the
1999/2000 financial year. But these situations proved to be comparatively infrequent
– fortunately for Investec.
As suggested earlier, the performances of the two managers were affected by the
different styles of management. Investec’s more ‘positive’ approach towards the use
of the range of instruments available to it did produce its rewards. Merrills relative
performance was less volatile but less spectacular as the table below shows. The
main observations from the two tables can be summarised as follows:
 Investec outperformed Merrill Lynch, the 7-day deposit rate benchmark and the
industry average in two of the three years.
 Merrill Lynch’s investment approach provided better protection in the year when
markets presented a disappointing environment for fund managers (1999/2000)
but fell short of the industry average on all three occasions.
 Merrills did beat the benchmark in two of the three years. The margin of return
above and below this measure was less pronounced than Investec.
 Investec’s performance was in the top quartile of the industry in two years and
was at the median in the other. It was top performer in 1998/99 and just short of
this position in 2000/01.
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Annexe 1

Merrill’s performance was on the upper quartile in 1999/2000 but in the second
quartile on the two other occasions.
Summary Statistics
Net Performance
Investec
MLIM
1998/99
1999/00
2000/01
8.66
7.80
4.79
5.21
7.44
6.15
8.20
8.04
7.49
5.21
4.79
4.52
6.87
6.73
6.48
7.91
4.91
6.72
8.66
7.33
5.94
4.21
7.50
6.15
6.92
5.32
5.94
Quartiles
Upper
Median
Lower
Industry
Average
High
Low
Benchmark
Comparative Returns
Year
v. b’mark
1998/99
+1.74
1999/00
-0.53
2000/01
+1.50
Investec
v. ind ave
+0.75
-0.12
+0.71
v. Merrills
+0.86
-0.42
+1.29
v. b’mark
+0.88
-0.11
+0.21
Merrill Lynch
v. ind ave
v. Investec
-0.11
-0.86
+0.30
+0.42
-0.58
-1.29
On the whole, therefore, the experience of the Council has been mixed. It has not
suffered from the appointment of a manager who has failed to deliver a satisfactory
set of returns. The different styles of investment did hold some advantages in terms
of risk distribution. However, this, more than anything else, had a significant bearing
upon relative performances.
It would be difficult to criticise Investec for the results it had produced although there
were times when luck went their way. It is a manager that is prepared to take a
strong view on markets and to utilise the investment parameters it has been set to
the full. In view of this somewhat aggressive style, a manager that provides a more
cautious foil can be a useful advantage. Merrill Lynch can be viewed as fulfilling this
role, although it could be accused of being a little too timid and too reluctant to take
strategic positions in the gilt-edged market. They have proved to be a safe bet in the
past and there is no reason to believe that this situation will alter in the future. But the
returns of other managers since 1998 do show that the options now available to local
authorities have expanded and these are certainly worthwhile exploring.
With regard to the Council’s external fund managers the Council should:
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Annexe 1
 Consolidate the two existing funds to take into account the estimated reduction in
the total amount of resources available for investment to approximately £13
million four years hence.
 Re-examine the alternative fund managers capable of providing a comprehensive
investment service for surplus capital funds. The number of managers and the
variety of service provided has expanded greatly since the Council’s funds were
first set up.
 Consider altering the investment policy guidelines of the new fund manager to:1. Ensure returns are optimised in the environment of a reduced number of
managers
2. Limit the new portfolio’s exposure to interest rate and credit (counterparty)
risk.
Due regard should be given to the range and maturity of instruments utilised, the
limit on the fund’s average duration (exposure to potential volatility), the
percentage limits imposed upon exposure to different asset classes.
Examine the opportunities made available by the Council’s debt free status –
specifically the scope to enhance returns via the use of non-approved investment
instruments. Embarking down this route is not necessarily synonymous with
increased risk. Careful regard to permitted investment parameters and wider
exposure to different instruments and counterparties can help to reduce the risks
faced by funds that concentrate upon the narrower range of Approved Investment
Instruments.
Our review of the investment activity and performance of internally managed fund
has highlighted a number of features, not least the disadvantages of not utilising the
entire money market yield curve. Of course, the Council’s ability to adopt a more
wide-ranging investment approach very much depends upon the extent to which the
funds that are available form part of its short-term cash flows or can be committed for
longer periods. We draw a number of conclusions which are itemised as follows:
The Council should:
 Analyse its short-term cash flow requirements with the aim of identifying a core
element of cash that can be committed for up to one year or even longer.
 Use this core element to pursue of a more active investment stance in the money
markets, utilising, in particular, the entire area of the yield curve out to 364 days.
 Consider investment in alternative Approved Investment Instruments, especially
the gilt-edged market if and when they are both attractive and do not compromise
the principle of the preservation of capital.
 Consider the investment of short-term cash flow funds in recognised Money
Market Funds, when permitted. These will offer the advantages of relatively
attractive short-term rates of interest, a high degree of flexibility and no difficulty
with respect to investment in credit counterparties. It would also free-up at least
some time spent by the Council’s investment officer in his day-to-day dealing role,
time that might be put to more productive use.
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