Benchmarking Your Portfolio

1. Benchmarking Your Portfolio January 13, 2011By: David Witthohn, CFA, CIPM, Director

2. Why Benchmark Your Portfolio?

3. What is the Purpose of Benchmarking? Why wear a watch? Why have a speedometer? • Establish a Standard – Minutes, Speed or Return • Measure Progress – Next Break, Destination or Goals & Objectives • Set Limits – Time, Speed or Risk

4. Isn’t It Just All About Performance? Would you buy a U.S. Treasury Bond with a yield of 4.27%? It’s about performance and risk Risk/Return Tradeoff

5. Portfolio Objectives • Preserving principal • Providing sufficient liquidity to meet cash flow demands • Achieving a market rate of return

6. Benchmark used to Achieve Portfolio Objectives A good benchmark can be used to measure all of the following: • Safety – How much credit risk is in the portfolio? How much interest rate risk? How long is the portfolio’s average maturity? • Liquidity - Can the assets be sold? Are there sufficient funds available to meet cash demands? • Return – What is a market rate of return? Is the portfolio under invested?

7. Performance Measurement

8. Measuring Return There are two different prospectives: • Yield Approach • Pros • Assumes held to maturity • Simplifies calculations • Smoothes earnings • Makes projections easier • Bases return on true income • Cons • Ignores price movement • Hides risk • Approximates performance • Total Return Approach • Pros • Industry standard • Shows all risks • Gives an accurate value • Allows comparability • Cons • Difficult to calculate • Hard to capture return • Return is erratic

9. Yield Approach – Yield to Maturity (YTM) Assumptions: • Looks only at the income from the bond • Yield-to-Maturity (purchase yield) • Reinvestment of interest at the YTM • Security held to maturity with no optionality (non-callable) • Annualized for comparison purposes • Approximation of true yield

10. Yield to Maturity

11. Yield to Call Yield-to-Call and Yield-to-Worst • Adjusts the yield based on a call date • Uses the market price as an indication of which securities will be called

12. Yield to Call

13. Amortized Cost Amortized Cost Method Return = (Interest +/- Accretion/Amortization +/- Realized Gain/loss) Average Daily Historical Cost • Annualize: divide by # of days in the period and then multiple by 365 • Captures sales and purchases, maturities, and called securities • Calculates actual reinvestment rate • Calculates return for period – not just a point in time

14. Total Return – Industry Standard Total return performance combines both income and change in price. Total Return = Value End – Value Start Value Start • Doesn’t allow for cash flows for the period (no additions or subtractions) • Assumes you will sell the security today using the current price • Changing prices varies return from period-to-period • Global Investment Performance Standards (GIPS) – These are client returns adjusted for any cash flows

15. Total Return vs. Yield to Maturity (YTM)

16. Total Return – Price vs. Income Total Return – 5.52% Income Return – 5.51% Price Return - .01%

17. Benchmark Selection • When you select an Index as your benchmark ideally want it to reflect what you are doing in the portfolio. Here are some issues that you might not have thought about: • Indexes don’t include transaction costs • Indexes are passive • Indexes have no transactions

18. Benchmark Selection The transaction issue can be reduced by splitting the portfolio into liquid funds and core funds.

19. Traditional Portfolio Structure • Provide money market-like liquidity with incremental returns to traditional Rule 2a-7 funds • Capture money market return • Manage liquidity and credit risks • Reinvest cash flows timely (critical to achieving competitive return profile) • Capture best duration risk-adjusted returns with the “Core” portfolio • Allocate to government and high quality sectors, ensuring liquidity if needed Liquidity Portfolio 1 to 3 Years

20. Selecting a Benchmark For Your Core Portfolio

21. Drivers of Performance • There are three main drivers of portfolio performance for core funds. Generally these are short-term high quality portfolios: • Duration Effect – duration of portfolio • Sector Effect – allocation of portfolio • Selection Effect – securities in portfolio

22. Duration Effect – Selecting a Target Return vs. Number of Negative Quarters October 1, 2000 to September 30, 2010

23. Duration Effect - Risk/Return Tradeoff

24. Duration Management Cutwater adjusts target duration based on current market conditions. We favor a low-risk approach, using an asymmetrical range to limit market risk. When rates are at the upper end of the band, a duration that is 10% above target is appropriate. When rates are low, a target duration as low as 50% of the target limits market risk. Source: Bloomberg

25. Amortized Cost – Evaluating Market Risk

26. Amortized Cost – Evaluating Market Risk

27. Sector Effect – Asset Allocation It may be difficult to find a standard benchmark that completely matches your asset allocation. Here is an example:

28. Sector Effect – Asset Allocation It may be difficult to find a standard benchmark that completely matches your asset allocation. Here is an example:

29. Custom Benchmark • XYZ City Benchmark • Treasury 1-3 Year 10% • Agency 1-3 Year 80% • Corporate A+ 1-3 Year 10% • Blended Benchmark 100%

30. How to Communicate Using Benchmarks

31. Communicating Performance Using Benchmarks In communication it is helpful to show not only performance of the portfolio but also a measure of risk for the portfolio, like standard deviation or weighted average maturity

32. Benchmarking Summary • Benchmarks gauge portfolio return and portfolio risk • Portfolio return is linked to portfolio safety and portfolio liquidity • Performance can be measured by just income or by total return • Cash flow analysis splits the portfolio into Liquidity and Core portions • There are three primary drivers of portfolio performance • Duration is the primary driver of performance • Risk measurement is just as important as performance • Variation from the benchmark means active management