Approximately£4bn of cash is managed through this route yet the benchmark for these funds has always been one particular index - the seven day rate. But very little attention has been devoted to challenging whether it is the most appropriate index.
I believe the benchmark can make a difference and that it has two main functions. First, to base an achievable target upon - to ensure the manager adds value, and second, to reflect the market the manager has been asked to operate in.
Obviously a manager is employed to add value, but what is less obvious is why
the benchmark affects performance. The current benchmark is a very short index and over an interest rate cycle is probably the easiest rate to achieve. Part of the reason why it was chosen in the first place was because, as a passive benchmark, it was thought a council could achieve this level of return in-house - anything above this was defined as added value.
But perhaps a more suitable benchmark would be the one year sterling bid rate. This benchmark reflects that as the cash is core it could simply be re-invested on the 1 April each year giving certainty of return for annual budgeting purposes. How would the return compare to the seven day rate?
If a strategy had invested£10m on the 1 April each year since 1 April 1991 on a one year deposit it would have generated a sum of£19.1m by the end of March 2000. A strategy adopting the seven day LIBID approach would have generated a sum of£18.2m. When comparing added value there is a significant difference between these two alternative benchmarks.
But what does the above mean? If you are paying a manager to outperform a benchmark, then a higher benchmark will force the manager to work harder to outperform the new target. It could be argued that you simply adjust the outperformance target, ie instead of 10% above the seven day LIBID you would have 5% above the one year. Clearly this depends upon what you expect from a manager.
The seven day LIBID is too easy a benchmark and does not adequately reflect what a council could reasonably expect to earn without expert advice. Perhaps a more suitable benchmark would be the average one year sterling bid rate, but I am open to challenge on this point.