In the first phase, the relationship between the assets and liabilities to which a firm is exposed is determined. These exposures can be characterized by cash flows. Mismatches between the timing or nature of these exposures constitutes risk.

The timing of investment cash flows is driven by operational cash flows and liability needs. The financial cash flows are timed to smooth out the total volatility of cash flows. Therefore a perfectly hedged business is one in which cash deficits/surpluses due to operational activities and liability needs are exactly offset by surpluses/deficits from investment activities.

In the example below, investment cash surpluses are timed to offset operational cash deficits to ensure that the business is always in a cash surplus position.

Structuring this hedge is the main goal of a passive management strategy. Unfortunately, the perfect hedge requires perfect forecasts of business activity (cash flows arising from that activity) and investment activity (economic and market forecasts). Since this is usually not possible, the prudent investment manager will attempt to always hold a certain surplus in cash (money market instruments such as treasury bills and commercial paper are considered to be cash since they are easily bought and sold). A good analogy is treating cash as an inventory problem, where too much cash (or inventory) is costly due to a poor return on investment, whereas a cash deficit is costly because bonds and other securities must be liquidated. The objective in passive asset liability management is to find the optimal strategy to minimize these costs. An active investment strategy on the other hand, will deviate from this hedge in order to gain excess returns from favorable moves in the market.

Included in Phase One is the creation of a realistic economic forecast. The objective is to construct a long term forecast, not a short term one. There is a tendency amongst investors and analysts to focus too much attention on the “noise” in the market which occurs over periods of days to several months. When developing an investment strategy, the investor should be looking over several years, discussing long term trends such as fundamental shifts in government policy, technological changes, demographic changes etcetera.

The last part of Phase One is to generate an overall profile of the investor’s needs. This is a combination of the risks, returns, costs and constraints which the investor faces. It is analogous to juggling three balls, the investor having to manage all three at the same time. Mistakes tend to be made when too much attention is focused on only one ball.

The most difficult of the three items to deal with is risk. For most organizations, the most crucial element of risk is managing cash flow volatility. From the investment perspective, cash flow volatility can be the result of a number of different risks. Some of them are:

• Market risk
• Reinvestment risk
• Inflation risk
• Gap risk
• Credit risk
• Liquidity risk
• Interest rate risk

These risks must be managed within the bounds of the costs and constraints facing an organization. There are a number of costs which organizations face, all of them are not necessarily obvious. The main ones are:

• Taxes
• Inflation
• Trading Costs
• Market Impact
• Bid / Ask Spreads
• Opportunity Costs
• Commissions
• Regulatory
• Limited Selection of Asset Classes
• Limited Selection of Securities
• Liquidity Requirements
• Credit Requirements
• Volatility Requirements
• Liquidity
• Management Costs

Finally, the return forecasts which were generated in the economic analysis are included into the overall profile.

Value is added by determining the optimal Risk, Return, Cost & Constraint balance for a given set of circumstances. In striking this balance, the investor attempts to predict and control each of these variables. Each must be treated in a different way, however. The investor has the most control and best predictive ability over cost and constraints, and the least control and predictive ability over returns, with risk falling between the two.

There is a tendency amongst investors to believe their control and predictive powers over return are greater than what actually exists. They tend to consider successes a result of skill and failures a result of bad luck. This excessive confidence results in too much attention focused on attempting to predict returns and not enough on the more mundane tasks of predicting and controlling risks, costs and constraints. By establishing more efficient controls over costs, constraints and risk, the investor has a higher likelihood of achieving consistent and higher long term returns.