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Davidson Fixed Income Management Deanne Woodring, CFA Managing Director (866) 999-2374

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 (866) 999-2374 www.DavidsonFIM.com Dwoodring@dadco.com.

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Davidson Fixed Income Management Deanne Woodring, CFA Managing Director (866) 999-2374

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  1. 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 (866) 999-2374 www.DavidsonFIM.com Dwoodring@dadco.com

  2. 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

  3. 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.

  4. Reality 2008 – Public Fund Cash Management Process 4 Davidson Fixed Income Management

  5. Principles Of Investing Considerations when: 1. Buying a house 2. Buying a car 3. Investing in retirement

  6. 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.

  7. 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

  8. 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

  9. US Treasury 2 Year Note12/31/97 – 12/31/07

  10. US Treasury 2 Year Note12/31/07 – 03/04/08

  11. 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

  12. Facts of public fund investing • Interest rates change. • Your entity’s 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.

  13. Best Practice Benchmark Considerations Incorporate Objectives • LIQUIDTY = Cash Flow – Liquidity vs. Core • SAFETY = Asset Allocation - Diversification • RETURN = Market Risk Exposure Duration

  14. A Market Benchmark in Review • Basket of fixed income securities that reflect your entity’s 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

  15. 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

  16. 1.Evaluate Return ExpectationsBased on Duration Ending Value and Return - Manage Duration $10,000,000.00 Invested Over the Last 10 Years Source: Merrill Lynch indices

  17. Evaluate ReturnBased on Duration Ending Value and Return- Manage Duration $10,000,000.00 Invested Over the Last 5 Years Source: Merrill Lynch indices

  18. Evaluate Return Based on Asset Allocation Ending Value and Return- $10,000,000.00 Invested Over the Last 5 Years Source: Merrill Lynch indices

  19. Outperforming Asset Classes do not repeat year to year YearWhat Happened2 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%

  20. Evaluate Return Based on Yield Curve Ending Value and Return- $10,000,000.00 Invested Over the Last 5 Years Source: Merrill Lynch indices

  21. 2. Determine Acceptable Risk ToleranceMark to Market $10,000,000 Portfolio • 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

  22. 2. Determine Acceptable Risk Credit Diversification

  23. 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

  24. Standard Index Comparison to Practice

  25. Standard Index versus Custom Index based on Legal Parameters

  26. Standard Index versus Custom Index based on Legal Parameters

  27. Davidson Fixed Income Management 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 27

  28. 4. Establish Duration Targets Historical Yield Levels

  29. 6.0% Yields Rise Duration (Risk/Reward) Increases Duration/Yield Relationship 4.20% Yields Decline Duration (Risk/Reward Declines Neutral point – duration is at neutral point when yield is at average 2.0% .90 1. 1.20 1.4 1.5 Duration Neutral 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.

  30. 5. Determine Guidelines

  31. Guidelines

  32. 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

  33. Monitor Portfolio Compared to Benchmark ReturnsRisk Portfolio BenchmarkPortfolio 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

  34. Monitor Portfolio Compared to Benchmark ($100,000,000 Portfolio) Benchmark: US Treasury 1-3 Duration: 1.65

  35. 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.

  36. 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?

  37. Answer – What If Scenario duration

  38. Other Scenarios

  39. What do you buy? Recommendation: Buy 2 year bullet agency

  40. BEST PRACTICE BENCHMARK 2008 and Beyond Comply Comply Comply

  41. How to implement? • Evaluate Internal System and Expertise • Cost/Benefit Analysis of Outsourcing - Advisors • Evaluate Value of Improved Process

  42. 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

  43. BENCHMARK RESOURCE www.DavidsonFim.com

  44. TOP TEN ISSUES • CASH FLOW • DIVERSIFICATION OF LIQUIDITY AND INVESTMENTS • DIVERSIFICATION OF MATURITY AND DURATION • DIVERSIFICATION OF ASSET CLASS • KNOW THE RISKS IN YOUR PORTFOLIO • KNOW THE CURRENT MARKET ENVIRONMENT • HAVE A STRATEGY • ESTABLISH GUIDELINES • COMMUNICATE • MONITOR THE PORTFOLIO

  45. MARKET OBSERVATIONS

  46. THE LAST EASE

  47. Today- Treasuries have lead ease

  48. Where are Fed Funds Rates and Short Rates Headed?

  49. YIELD CURVE

  50. HAVE A PLAN

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