Portfolio Management 2 Tools for Analyzing Trades

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Benchmarking for Public Fund Investment
Guidance and Performance BEST PRACTICES Safety,
Liquidity and Return
OMFOA - 2008
Davidson Fixed Income Management Deanne Woodring,
CFA Managing Director [phone] www.DavidsonF
IM.com Dwoodring_at_dadco.com
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Encompassing Portfolio Management Tools
Effect Purchase date Maturity of Portfolio
Yield
Investment Policy
Benchmark Process
Process Control Risk Manage Return
Accountability Strategy
Framework Maturity Asset Allocation Broker
Relationships Define Goals
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Prudent Portfolio Management

• The measure of success in managing public fund
  dollars lies most appropriately in safety and
  liquidity, with yield there after.
• Dan Dowell
• Chief Investment Officer
• State of California
• However, there is a responsibility as public
  fund steward to manage safety, liquidity and
  returns through process, discipline and planning.

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Reality 2008 Public Fund Cash Management
Process
Investment Policy Political and Internal Environment Risk Return
Safety Liquidity Market Rate of Return Board Investment Committee Staff Turnover Resources (Experience, time, software, etc.) Safety Liquidity Cash-Flow Mark to Market Political Book Yield Accrual Performance (Mark to Market) Optimizing the Growth of Funds
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Davidson Fixed Income Management
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Principles Of Investing

• Considerations when
• 1. Buying a house
• 2. Buying a car
• 3. Investing in retirement

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Principles Of Investing Growth

• Considerations when
• 1. Buying a house Timing (Market Conditions)
• Location (Where to buy)
• Objectives (What fits your profile)
• Time Horizon
• 2. Buying a car Type of car
• Resell Value
• Objectives
• Time Horizon
• 3. Investing in retirement
• Objectives
• Best Returns Growth Value
• Time Horizon
• Each consideration will generate a different
  outcome or dollar value at the end of period of
  time.

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Yield versus Return

• Yield to maturity Is an assumption of return
  based on interest rates at the time the bond is
  purchased and assumes that all cash flow
  generated from the bond will be reinvested at YTM
  rate.
• Return Incorporates what really happens to the
  investment over a period of time.
• Changing Interest rates Impact
• 1. Value of the bonds
• 2. Reinvestment Rates
• 3. New purchase rates

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Does it matter how you invest?

• LETS LOOK AT THIS YEAR 2007
• 10,000,000.00 or 100,000,000.00
• Pool Funds Average Return for 2007 5.10
• 10,000,000.00 10,510,000
• 100,000,000.00 105,150,000
• 0-3 Year Treasury Portfolio - 1.2 year Maturity
  6.635 Book Yield 5
• 10,000,000.00 10,663,500
• 100,000,000.00 106,635,000.00

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US Treasury 2 Year Note12/31/97 12/31/07
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US Treasury 2 Year Note12/31/07 03/04/08
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SAFETYSmoothing Out Interest Earnings

• Assumptions
• Current Portfolio Size 50,000,000
• Liquid Portion (50) 25,000,000
• Core Portion (50) 25,000,000
• Historical Average Rates for last 10 years
  (12/31/97 12/31/07)
• Liquid 4.0 (Average Pool Funds)
• Core 4.43 (US Treasury 0-3 year)
• Benchmark
• US Treasury 0-3 year Duration 1.2 yrs

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Facts of public fund investing

• Interest rates change.
• Your entitys cash flow requirements change.
• Your investments and earnings are impacted by
  changing rates.
• Forethought into the investment strategy is
  important. It can have a substantial impact in
  your earnings outcome.
• Strategy is important and can be applied to any
  size portfolio.

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Best Practice Benchmark Considerations
Incorporate Objectives

• LIQUIDTY Cash Flow Liquidity vs. Core
• SAFETY Asset Allocation - Diversification
• RETURN Market Risk Exposure Duration

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A Market Benchmark in Review

• Basket of fixed income securities that reflect
  your entitys risk and return profile
• Standard investment management tool
• Provides guidelines for investment decisions and
  portfolio positioning
• Typically used for funds in excess of liquidity
  requirements (core funds)
• Effective in managing expectations within your
  organization

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Strategy Utilizing Benchmarks

• STEPS
• Evaluate return expectations
• Determine acceptable risk tolerance
• Establish appropriate benchmark
• Establish duration targets
• Determine guidelines
• Monitor and report performance
• Rebalance the portfolio

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1. Evaluate Return ExpectationsBased on Duration

• Ending Value and Return - Manage Duration
• 10,000,000.00 Invested Over the Last 10 Years

Value Raw Return/ Annualized
ML 0-1 Year Treasury Index 0.5 duration 14,748,080 47.58 / 3.97
ML 0-3 Year Treasury Index 1.2 duration 15,434,000 54.34 / 4.43
ML 0-5 Year Treasury Index 1.85 duration 15,880,000 58.80 / 4.73
Source Merrill Lynch indices
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Evaluate ReturnBased on Duration

• Ending Value and Return- Manage Duration
• 10,000,000.00 Invested Over the Last 5 Years

Value Raw Return/ Annualized
ML 0-1 Year Treasury Index 0.5 duration 11,631,000 16.31 / 3.07
ML 0-3 Year Treasury Index 1.2 duration 11,651,000 16.51 / 3.10
ML 0-5 Year Treasury Index 1.85 duration 11,730,000 17.30 / 3.24
Source Merrill Lynch indices
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Evaluate Return Based on Asset Allocation

• Ending Value and Return-
• 10,000,000.00 Invested Over the Last 5 Years

Value Raw Return/ Annualized
ML 1-3 Year Treasury Index 11,738,000 17.38 / 3.26
ML 1-3 Year Bullet Agency Index 11,786,000 17.86 / 3.34
ML 1-3 Year Callable Agency Index 11,618,000 16.18 / 3.04
ML 1-3 Year AA or Better Corporate 11,826,300 18.263 / 3.41
Source Merrill Lynch indices
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Outperforming Asset Classes do not repeat year to
year
INDEX 2007 2006 2005 2004 2003
US Treasury 1-3 Year 7.317 3.96 1.67 0.91 1.90
US Agency 1-3 Year Bullet 7.124 4.46 1.72 1.15 2.37
US Agency 1-3 Year Callable 5.768 4.63 1.87 1.26 1.78
TIPS 1-3 Year 8.73 3.08 2.25  
1-3 Year Corp A-AAA 6.041 4.62 1.96 1.45 3.82
0-3 Yrs WAL Mortgages 6.948 4.64 2.15 2.80 1.83

• Year What Happened 2 Year Yield
  Change (y/y)
• 2007 Spreads widened, rates fell, inflation
  picked up 4.80 to 3.04
• 2006 Rates rose curve inverted 4.40 to
  4.80
• 2005 Spreads were flat, rates rose, inflation
  high 3.08 to 4.40
• 2004 Rate rose a little, curve flattened 1.83
  to 3.08
• 2003 Yields low, unchanged 1.59 to 1.83

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Evaluate Return Based on Yield Curve

• Ending Value and Return-
• 10,000,000.00 Invested Over the Last 5 Years

Value Raw Return/ Annualized
1 Year Sector Treasury 11,569,000 15.69/2.96
2 Year Sector Treasury 11,660,900 16.60/312
3 Year Sector _ Treasury 11,816,900 18.17/3.39
5 Year Sector - Treasury 11,917,200 19.17/3.58
Source Merrill Lynch indices
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2. Determine Acceptable Risk ToleranceMark to
Market
10,000,000 Portfolio
100bp/- 100bp/- 200bp/- 200bp/-
Index Duration P Value P Value
Merrill 0-1 Year .58 .58 58,000 1 116,000
Merrill 0-3 Year 1.2 2 120,000 2.4 240,000
Merrill 0-5 Year 1.85 1.85 185,000 3.7 370,000

• Value Change Calculation 100,000,000 (portfolio
  size) 1.2 (duration) .01 (rate move)
  1,200,000
• 2 YEAR TREASURY NOTE JUNE 1997 JUNE 2007
• Average annual yield change (high to low) was 153
  basis points
• Standard Deviation is 51 basis points
• One Standard Deviation range (68) is 102 bp to
  204 bp
• Two Standard Deviation range (95) is 51 bp to
  255 bp

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2. Determine Acceptable Risk Credit
Diversification

ASSET ALLOCATION TARGETS ASSET ALLOCATION TARGETS  
  State Code Policy Practice
Treasury 100 5
Agency Securities 100 80
Corporate 35 15
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3. Establish Appropriate Benchmark

• TWO CHOICES
• 1. Customize a benchmark that reflects your
  practices
• 5 Treasury 1-3 Year Duration 1.65
• 60 Agency 1-3 Year Duration 1.65
• 15 Corporate 1-3 Year Duration 1.76
• Average Maturity 1.66 years
• 2. Pick Standard Market Index
• 1-3 Agency Index Duration 1.65
• 0-3 Treasury Index Duration 1.2

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Standard Index Comparison to Practice
COMPARISON OF INDEX TO CUSTOM COMPARISON OF INDEX TO CUSTOM
INDEX 2007 2006 2005 2004 2003
US Treasury 1-3 Year 7.31 3.96 1.66 .907 1.89
US Agency 1-3Year 7.268 4.54 1.58 1.73 2.30
1-3 Year Corp AA-AAA 6.041 4.62 1.96 1.45 3.82

CUSTOM PRACTICE 5 Treasury 1-3 /80 Agency 1-3 / 15 Corporate Duration 1.55 6.69 4.49 1.77 1.18 2.31
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Standard Index versus Custom Index based on Legal
Parameters
COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07 COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07 COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07
INDEX 2007 2006 2005 2004 2003 10 Year
US Treasury 0-3 Year 6.635 4.24 2.10 .98 1.66 4.43
US Agency 1-3 Year Duration 1.65 6.73 4.52 1.77 1.18 2.18 4.97
1-3 Year Corp AA-AAA 6.24 4.56 1.86 1.29 3.18   5.37
Legal Maximum Custom 25 0-1 / 40 1-3 Agency /35 1-3 Corp Duration 1.29 6.24 4.57 2.06 1.21 2.30 4.85
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Standard Index versus Custom Index based on Legal
Parameters
COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07 COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07 COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07
INDEX 2007 2006 2005 2004 2003 10 Year
DFIM 0-3 Year Index 1.29 Duration - OREGON 6.47 4.58 1.98 1.18 2.00 4.76
Legal Maximum Custom 25 0-1 / 40 1-3 Agency /35 1-3 Corp Duration 1.29 6.24 4.57 2.06 1.21 2.30 4.85
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Establish Benchmark

• Select the Agency/Treasury 0-3 year Index
• Duration is appropriate
• Agency exposure appropriate
• Add value when spreads are wide on corporate and
  agency issues

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4. Establish Duration Targets
Historical Yield Levels
US Treasury Historical Average Rates Historical Average Rates Current Rates
5 Year (12/31/02 - 12/31/07) 10 Year (12/31/97 - 12/31/07) As of 3/7/08
3 Month 2.90 3.51 1.42
6 Month 3.09 3.65 1.51
2 Year 3.31 3.95 1.48
5 Year 3.82 4.38 2.40
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Establish Duration Targets
Benchmark DFIM 0-3 Treasury/ Agency 0-3
Year Benchmark duration 1.2 years (this is
your neutral position) 10 year Average rate on 2
year note is 3.9 Strategy Based on current
rates relative to historical rates portfolios
should be approaching their neutral positions.
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5. Determine Guidelines
Target size of core balance Benchmark to control risk and measure return 75MM- 100MM DFIM 0-3 year T/Agency Duration Approximately 1.2 years Asset allocation Within policy Maturity structure Within policy
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Guidelines
Duration rage of portfolio relative to /- 25 or duration benchmark Minimum .90years Maximum 1.5years
Asset Allocation Targets Neutral 5 Treasury 70 Agency 20 Callable 15 Corporate Securities
Strategy and timeline The portfolio will be adjusted periodically to reflect the above guidelines.
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6. Report on Portfolio
Liquidity Component of Portfolio
15MM State Pool or Short Term Money Market Issues
Rate 4.80
Core Component Of Portfolio - 12/31/07
Issue Acq Date Acq Yield Holding Duration (Years) Effective Duration (Years)
2,000M FFCB 4 1/18/08 5/5/05 3.858 20 .01 .01
1,000M FHLB 5.125 6/13/08 5/31/06 5.25 10 .5 .5
1,000M FFCB 4.125 9/26/08 9/13/05 4.571 10 .75 .75
2,000M FNMA 5.05 1/12/09-1/08 1/27/06 5.09 20 .9 .1
2,000M FHLB 5 5/15/09 6/15/06 5.25 20 1.2 1.2
1, 000M FHLMC 4.875 2/9/10 2/10/07 5.000 10 2.4 2.4
1,000M FHLB 5.375 9/8/10-9/08 Callable 6/30/07 5.375 10 2.8 1.0
10,000,000 4.85 100 1.08 .74
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Monitor Portfolio Compared to Benchmark

• Returns Risk
• Portfolio Benchmark Portfolio
  Benchmark
• 1/31/07 .307 .215 1.35 1.64
• 2/28/07 .791 .797 1.44 1.62
• 3/31/07 .356 .384
  1.53 1.68
• 4/30/07 .416 .356 1.43
  1.65
• 5/31/07 .001 -.074
  1.46 1.72
• 6/30/07 .423 .419 1.51 1.67
• 7/31/07 .729 .911 1.40 1.64
• 8/31/07 .637 1.028 1.24 1.61
• 9/30/07 .848 .708
  1.36 1.64
• 10/31/07 .435 .37 1.26
  1.61
• 11/30/07 1.073 1.718 1.32
  1.60
• 12/31/07 .414 .262 1.39
  1.61

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Monitor Portfolio Compared to Benchmark
(100,000,000 Portfolio)
Returns YTD - 12/07 Returns YTD - 12/07 Since Inception - 12/97 Since Inception - 12/97
Portfolio Benchmark Portfolio Benchmark
Raw Return 6.618 7.317 67.309 59.079
Annualized 6.618 7.317 5.28 4.75
VALUE ADDED SINCE 12/31/97 VALUE ADDED SINCE 12/31/97 VALUE ADDED SINCE 12/31/97 VALUE ADDED SINCE 12/31/97 VALUE ADDED SINCE 12/31/97
Portfolio 67,309,000
Benchmark 58,079,000
Pools (0-1) 47,580,000
DIFFERENCE Portfolio vs. Benchmark 9,230,000
DIFFERENCE Portfolio vs. CASH 19,729,000
Benchmark US Treasury 1-3 Duration 1.65
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7. Rebalance the Portfolio

• Conditions to Rebalance
• Large change in interest rates
• Large change in asset class valuations
• Time has shorten duration below guideline
• The yield curve has made a large shift
• OBJECTIVE OF REBALANCING
• To rebalance duration and asset weighting back to
  guideline levels.

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Rebalance Portfolio Decision Process

• Scenario
• Yields have dropped to 2.5 on the two year note
• Want to move portfolio out, but remain short to
  the benchmark
• 50,000,000 portfolio with 10,000,000 (20) in
  maturing bond
• Neutral Duration 1.2 years
• Current duration .75 years
• Target duration 1.0 years
• Question 1 What maturity do you buy?

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Answer What If Scenario duration
  Duration of Portfolio Weighted Portfolio Weighted Portfolio
Existing .75 80 .60  
Target Buy Issue 2.0 20 0.40  
New Duration       1.0
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Other Scenarios
Want to stay shorter the benchmark Want to stay shorter the benchmark Want to stay shorter the benchmark
  Duration of Portfolio Weighted Portfolio Weighted Portfolio
Existing .75 80 .6  
Target Buy Issue 1.0 20 .2  
New Duration       .80
If want to stay shorter but cant resist the yield on the 3year 3mth callable If want to stay shorter but cant resist the yield on the 3year 3mth callable
  Duration of Portfolio Weighted Portfolio Weighted Portfolio
Existing .75 80 .6  
Target Buy Issue 3/3 mth call 20 0.5  
New Duration       1.1
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What do you buy?
  Guidelines Actual Spreads Value
Treasury 5 0 0  
Agency Bullet 50 50 Wide ADD
Agency Callable 20 30 Wide
Corporate 15 15 Wide  
Recommendation Buy 2 year bullet agency
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BEST PRACTICE BENCHMARK 2008 and Beyond
BEST PRACTICE BENCHMARK BEST PRACTICE BENCHMARK BEST PRACTICE BENCHMARK
SAFETY LIQUIDTY MARKET RETURN
   
Diversification Requirements Book Yield
Quality Maintenance Benchmark Return
 

 
Comply
Comply
Comply
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How to implement?

• Evaluate Internal System and Expertise
• Cost/Benefit Analysis of Outsourcing - Advisors
• Evaluate Value of Improved Process

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Benefits of a Benchmark Strategy

• Clear Sense of Direction
• Focus in Overall Portfolio vs. Yield
• Accountability to Decision Making Process
• Balances Risk and Return
• Communication, Communication, Communication
• Confidence and Peace of Mind

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BENCHMARK RESOURCE

• www.DavidsonFim.com

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TOP TEN ISSUES

1. CASH FLOW
2. DIVERSIFICATION OF LIQUIDITY AND INVESTMENTS
3. DIVERSIFICATION OF MATURITY AND DURATION
4. DIVERSIFICATION OF ASSET CLASS
5. KNOW THE RISKS IN YOUR PORTFOLIO
6. KNOW THE CURRENT MARKET ENVIRONMENT
7. HAVE A STRATEGY
8. ESTABLISH GUIDELINES
9. COMMUNICATE
10. MONITOR THE PORTFOLIO

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MARKET OBSERVATIONS
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THE LAST EASE
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Today- Treasuries have lead ease
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Where are Fed Funds Rates and Short Rates Headed?
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YIELD CURVE
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• HAVE A PLAN

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• THANK YOU