Survey reveals preference for passive investing. (Forum).

A new survey by GFOA and MBIA Municipal Investors Service Corporation sheds some light on how public investors are managing their funds in the current low-interest rate environment. The 2002 Survey on Investment Practices in Today's Market reveals that public investors continue to rely on passive investment strategies, even though prevailing low interest rates tend to motivate investors to pursue more aggressive strategies. And despite recent widespread media coverage of conflicts of interest by broker/dealers, public investors do not perceive such conflicts to be a significant problem in the fixed income market.

The survey was e-mailed to 1,600 public finance officials in May 2002. More than 400 of these individuals, representing a wide variety of geographic regions and types of government, responded to the survey. The questions focused on four specific areas: investment strategies, use of broker/dealers, sources of investment advice, and sources of market information. Key findings in each of these areas are discussed below.

Investment Strategies

What type of investment strategy are public investors pursuing in light of a struggling economy and historically low interest rates? According to the survey, 84 percent of the respondents still use a passive investment strategy, characterized by buying securities and holding them until maturity or investing in benchmark products designed to yield the market rate of return. Respondents cited lack of resources, including time and staff, as the main reason for employing a passive investment strategy. Despite the tendency toward passive management, 37 percent of the respondents did sell a security prior to maturity in the last two years. Fifty-five percent of those who sold a security prior to maturity indicated that they did so to execute a swap into an alternative security, while 42 percent did so to either meet liquidity needs or balance their portfolios.

To cope with low interest rates, 42 percent of the respondents purchased callable securities. Callable securities allow debt issuers the option of repaying part or all of an issue early if interest rates decline further. Extending maturities to yield a higher return and increasing the liquidity of portfolios were other popular strategies for coping with low interest rates (Exhibit 1). Only 13 percent of the respondents shifted from a passive to an active investment strategy over the last two years, and nearly a quarter did not change their strategies at all.

Use of Broker/Dealers

In April, the State of New York filed charges against Merrill Lynch, claiming that the investment firm's research analysts gave favorable ratings to the stocks of companies doing investment-banking business with Merrill Lynch. As part of a settlement reached with the State of New York in May, Merrill Lynch agreed to pay $100 million in penalties and promised to sever the link between analyst compensation and investment banking. At approximately the same time, the Securities and Exchange Commission launched a formal inquiry into the practices of research analysts.