Best Practices for Public Fund Investment Guidance and Performance Deanne Woodring, CFA, MBA President, Senior Portfolio Advisor Luke Schneider, CFA Managing Director, Portfolio Advisor 1
FACTS: Rates are still low Agency spreads are tighter than ever Sounds like rates will be higher in 2015 LGIP pool remains lower than ever Budgets continue to get squeezed Considerations to Address : Mark to Market Entities are seeing negative market values if invested longer than 2 years Internal Controls - Internal controls continue to be a topic and need to be reviewed Oversight - Boards and oversight committees are becoming more active and interested in the portfolio Disclosure - Properly articulating the risks in public fund investment portfolios is on the radar 2
Discussion Today Review best practices for public fund investing Discuss the core competencies required for a best practice investment program Breakdown the steps of implementing a dynamic investment program utilizing benchmarks as your guide 3
Trends in Public Fund Investing Review best practices for public fund investing Discuss the core competencies required for a best practice investment program Breakdown the steps of implementing a dynamic investment program 4
Continued Trend from last year in Public Fund Investing Fiduciaries are becoming more interested in how investments are being managed and want to be included in the process Creating a forum for them to provide input is important. Having a well-articulated investment strategy will assist in managing these issues 5
Overview of Market Conditions FOMC continues to hold rates at 0-.25% Rates have been at these low levels since the financial crisis in September 2008 6
Liquidity Rates
2 year note
Allowable Securities for WA Public Funds State LGIP Bank Deposits Commercial Paper US Treasury US Agency Securities 9
Risk/Return Balance RISK - $30MM Mark to Market Risk 1% rise in rates = -$300,000 market value change. Reinvestment Risk If locked out then there are not funds to reinvest at higher rates Credit Risk- Limited credit exposure RETURN Maturity Extension Liquidity/Investment Component Quality 10
Investment Program Priority and Strategy through the low rate environment period Safety: Maintained high quality security holdings and shorter maturities Liquidity: Maintained liquidity balances Yield: Maintained a spread of 40 basis points over the pool Positioned for higher rates: Maturities coming due and will be invested at higher rates Liquidity balances that can be invested at higher rates. Maturities do not exceed 3 years 11
LIQUIDITY Sample of City Current Holdings As of 12/31/13 Issuer Amount Rate Percent Total Bank of America Deposit $2,125,316.20.25% - Compensating Balances WA LGIP $7,824,910.18.10% Target : $7MM - $10MM $9,950,226.38.15% 40% INVESTMENTS Par Issuer Name Coupon Maturity Yield Percent Total 2,000,000 FHLB.375 1/27/14.39% 2,000,000 FNMA.875 8/28/14.535% 2,000,000 FNMA.75 12/19/14.567% 2,000,000 FHLMC 1.75 9/10/15.313% 2,000,000 FHLB.50 11/20/15.513% 2,000,000 FNMA.52 5/27/16.744% 2,000,000 FFCB.75 6/14/16.749% 2,000,000 FHLMC 2.00 8/25/16.482% 17,000,000 2.06.532% 60%
Performance of Portfolio Since 2006 $2,500,000 Portfolio and WA LGIP Returns 6.00% $2,000,000 5.00% $1,500,000 $1,000,000 4.00% 3.00% 2.00% City Return WA LGIP Pool Returns Bremerton Return Average Pool Return $500,000 1.00% $- 2007 2008 2009 2010 2011 2012 0.00%
Signs of Higher Rates 5 year note over the last year
Conclusion Goals of the program: 1. Conservative investment practices 2. Disciplined approach 3. Preserve Principal 4. Achieve market rates of return 15
Core Competencies Required to Produce an Effective Management Process Core Competencies DUE DILIGENCE TIME RESOURCES EXPERIENCE Multi-task, Responsibilities, Efficiencies Knowledge, Market Expertise and Confidence Reporting, Bloomberg, Advisors, Brokers, Access to the Markets Investment Policy, Compliance, Internal Controls 16
Effective Investment Program Involves an Investment Strategy around Safety, Liquidity and Return Yield Investment Policy Strategy Process Transparent and Clearly Communicated Process 17
Steps Involved in Best Practice Program 1. Investment Policy 2. Define Liquidity and Core Investment Balances 3. Establish Benchmarks to Control Risk and Measure Returns 4. Report and Monitor for Transparency and Accountability 18
Investment Policy Scope Objectives Reporting Requirements Standards of Care/ Safekeeping and Custody Investment Parameters Authorized and Suitable Investments 19
Investment Policy Adoption and Review Have a statement of adoption Have a statement of review Policy 20
Best Practice Investment Considerations Incorporate Policy Objectives FIRST PRIORITY SAFETY = Asset Allocation & Diversification LIQUIDITY = Cash Flow & Liquidity Needs SECOND PRIORITY RETURN = Market Risk Exposure, Duration 21
How benchmarks can be utilized to incorporate the policy objectives? Creates guidelines for liquidity, safety and return Provides accountability to the decisions Provides for the ability to communicate clearly within your organization Each benchmark is specific to the profile of your organization in regards to safety, liquidity and return 22
The Utilization of a Benchmark as Part of that Process and Policy Why use benchmarks? Use to measure and compare actual to targets Compare performance More importantly: Guides your decision making More accountable to decisions Supports your plan 23
What is a Benchmark? A standard used as a comparison or measure. Define the following benchmarks for your portfolio: Liquidity Benchmark Safety Benchmark Return Benchmark 24
Addressing Liquidity- Benchmark What amount of cash do you need to have on hand or keep under six months in maturity. Pull up historical cash balances for the last 3 years. Liquidity fund must stay in short instruments such as the State pool, CDs and Money Market Instruments, typically under six months. 25
Reviewing Historical Cash Flow 26
Reviewing Historical Cash Flow 2012 2013 2014 Average $141,734,706.47 $147,627,087.85 $138,927,882.02 Max $153,923,412.37 $160,599,986.95 $146,455,127.70 Min $135,588,442.74 $140,310,155.85 $132,159,132.35 Largest Drawdown $6,243,439.98 $20,289,831.10 $20,591,524.28 27
Liquidity versus Core Fund Liquidity Fund Core Fund 28
Benchmark #1- Liquidity Liquidity Ranges are developed as the benchmark to manage expectations. Total Average Balance $140,000,000 Total Low Average Balance $120,000,000 Total Maximum Average: : $160,,000,000 Liquidity Range: $20,000,000 - $60,000,000 Investment Target : $100,000,000 If liquidity balances are outside of these ranges then cash flows should be checked 29
Addressing Safety The policy should constrain your portfolio. Just because you are allowed to buy it by state statute doesn t mean you should. Know what your are investing in Establish the diversification 30
Safety: Asset Allocation and Diversification Credit Risk: The risk associated with the failure of a security to pay. Interest Rate Risk: The risk of change in market value when rates rise. (Utilize duration to manage risk). 31
Addressing Safety- Benchmark Which allowable securities present credit risk to your entity? In this current market, probably all of them: Treasury Agency Bank Deposits Commercial Paper Municipal Bonds Diversification is the key tool to manage this but what should your diversification targets look like? 32
Benchmark # 2 - Safety Issuer Specific Name Policy Benchmark Current Holdings Current Strategy US Treasury 100% 10% 7% Underweight US Agency 100% 75% 62% Overweight FHLB 50% 20% 24% Overweight FHLMC 50% 10% 10% Neutral FNMA 50% 10% 8% Underweight FFCB 50% 10% 12% Overweight Bank Deposits CD s 25% 10% 14% Neutral Municipal Bonds 20% 10% 10% Neutral State LGIP 100% 10% 6% Underweight STRUCTURE TYPE Non- Callable N/A 70% 68% Underweight Callable N/A 30% 32% Overweight 33
Addressing Return Expectations Should a priority be return since it is an objective? Do you have a responsibility to achieve market rates of return? How do you determine the appropriate return goals Is your neighbor? Is it the pool? Can you use your own benchmark? What should you use to measure? Liquidity component will earn short money rates but how you invest the core fund matters.. 34
Returns Benefits of Diversified Maturity Structure Assumptions Current Portfolio Size: $100,000,000 Liquid Portion (25%) $25,000,000 Core Portion (75%) $75,000,000 Blended Portfolio Duration: 0.90 years Historical Average Rates for last 10 years Liquid:.15% Core:.75% Benchmark US Treasury 0-3 year Duration: 1.45yrs 12 Months Earnings Based on Changing Rate Tomorrow Liquid/Core Rates All Liquid Liquid/Core Interest Only Interest and Mark Change Stay the Same $150,000.00 $600,000.00 $600,000.00 0.1500% 0.60% 0.60% Increase 100 Bp $1,150,000.00 $1,037,500.00 $288,000.00 1.1500% 1.225% 0.288% 35
The Core Fund- Facts Designated investment component of the operating fund that can manage the risk and return of the portfolio in various market conditions. Within the core fund, the policy issues of safety and return can be refined and incorporated with a safety benchmark and return benchmark. The largest contributor to return is average maturity or duration over time. 36
Benchmark #3 - Return Public funds typically use a total return benchmark and a yield benchmark: Established Market Benchmark for Risk and Return Example: US Treasury 0-3 year Duration 1.45 Yield benchmark for overall portfolio can be the state pool or a rolling 6 month bill 37
Strategy Utilizing Market Benchmarks to control risk and return STEPS: 1. Evaluate return expectations 2. Determine acceptable risk tolerance 3. Establish appropriate benchmark 4. Establish duration targets 5. Determine guidelines Asset Allocation 6. Monitor and report performance 7. Rebalance the portfolio 38
Definition of Duration It is a tool that fixed income managers use to approximate the price change in a portfolio or a security given a change in rates. It is the Sum of the Present Values of Future cash flows Facts: Longer Maturity Longer Duration Higher the Coupon Shorter Duration Higher Reinvestment Rates Shorter Duration It is a measure of time and will always be shorter than the Weighted Average Maturity (WAM) Calculation = Duration * Market Value*rate Change = Market sensitivity 39
Strategy Utilizing Market Benchmarks to manage Risk and Return Expectations STEPS: 1. Evaluate return expectations 2. Determine acceptable risk tolerance 3. Establish appropriate benchmark 4. Establish duration targets 5. Determine guidelines Asset Allocation 6. Monitor and report performance 7. Rebalance the portfolio 40
Step 1: Evaluate Return Expectations Based on Duration Ending Value and Return - Manage Duration $100,000,000 Invested Over the Last 10 Years (6/30/14) Index/Duration US Treasury 0-1 Year.58 Years US Treasury 0-3 Year 1.45 Years US Treasury 0-5 Year 2.25 Years 10 Year Earnings Raw Return $20,135,000 20.135 1.85% $26,318,000 26.318 2.36% $32,786,000 32.786 3.876% Annualized Return 41
Step 1: Evaluate Return Based on Asset Allocation Ending Value and Return- 6/30/14 $100,000,000 Invested Over the Last 5 Years Index Duration 5 Year Earnings US Treasury 0-1 Year US Treasury 1-3 Year US Agency 1-3 Year Bullet US Agency 1-3 Year Callable Corp A-AAA 1-3 Year Mortgages 0-3 WAL Raw Return Annualized Return Yield.52 $1,36,000 1.366%.272%.03% 1.90 $6,040,000 6.040% 1.18%.41% 1.85 $7,361,000 7.361% 1.43%.48% 1.61 $4,595,000 4.595%.902%.66% 1.94 $18,174,000 18.174 3.396 1.11% 1.52 $15,674,000 15.674% 2.955% 1.55% 42
Step 2: Determine Acceptable Risk Tolerance Based on Mark to Market $100,000,000 Portfolio Index Duration % Change 100 BP Value Change 100bp % Change 200 bp Value Change 200 bp US Treasury 0-1 Year.52.52% $520,000 1.04% $1,040,000 US Treasury 0-3 Year 1.45 1.45% $1,450,000 2.90% $2,900,000 US Treasury 0-5 2.25 2.25% $2,250,000 4.50% $4,500,000 US Treasury 1-10 Year 3.97 3.97% $3,970,000 7.94% $7,940,000 43
Step 3: Determine the Appropriate Benchmark for your Entity Benchmark Alternatives Duration Selection State Pool.20 years Treasury 0-1 Year.6 years Treasury 0-3 Year.1.45 Years x Treasury 0-5 Year 2.25 years 44
Historical Yield Levels US Treasury 5 Year Average 10 Year Average Current Rates 3 Month Bill.113% 1.585%.03% 1 Year Note.288% 1.98%.10% 2 Year Note.58% 2.04%.39% 5 Year Note 1.55% 2.745% 1.59% 10 year Note 2.69% 3.509% 2.837% 45
Step 4: Establish Duration Targets Benchmark: US Treasury 0-3 Year Benchmark duration: 1.45 years (this is your neutral position) Historical Average rate on 2 year note is approximately 1.5% Strategy: Based on current rates relative to historical rates portfolios should be approaching their neutral positions. 3.5% 2.0%.50% Duration/Yield Relationship Yields Decline Duration (Risk/Reward Declines 1.0 1.25 1.45 1.65 Duration Neutral Neutral point duration is at neutral point when yield is at average 2.03 Yields Rise Duration (Risk/Reward) Increases 46
Step 5: Determine Acceptable Risk Credit Diversification Type of Issue Policy Target Actual Treasury 100% Agency Bullet 100% 55% 45% Agency Callable 30% 20% 30% 47
6. Report on Portfolio Liquidity Component of Portfolio 30MM State Pool or Short Term Money Market Issues Rate.15% Core Component Of Portfolio 12/31/13 Issue Acq Date Book Yield % Portfolio Duration FHLB.875 12/27/13 3/16/11 1.05% 10%.49 FHLB.70 1/30/14 6/23/11.65% 10%.58 FNMA 1.25 2/27/14 8/19/10 1.25. % 10%.65 FNMA.375 3/16/15 11/29/12.35% 10% 1.70 FNMA 1.625 10/26/15 1/18/12.77% 10% 2.28 FHLMC.45 11/24/15 1/15/13.60% 10% 2.38 FNMA.875 8/28/17 9/6/12.84% 10% 4.05.55% 1.23 Years 48
Step 7: Rebalance the Portfolio Strategy Goal Current Duration.94 Years Target Duration 1.10 Years Change in Duration Needed.16 years % of Portfolio 10% $7,000,000 Maturity needed to purchase 1.6 Years Calculation.16/.10 49
Core Fund Only Book Yield Comparison Portfolio Yield Comparison Duration Current Yield 6/30/14 Rolling 1 year Period LGIP.15.10%.17% 2 Year Rolling Agency 1.85.42%.31% Core Portfolio 1.45.55%.76% 50
Investment Process should include: Maximum Maturity for Total Portfolio Asset Allocation Guidelines Strategy Based on Current Rates Reporting Operational Procedures 51
Investment Strategy: Passive Strategy Buy and Hold and do the same thing Active Strategy Shift the holdings based on market expectations. Benchmark Strategy Balance Passive and Active to meet the portfolio objectives. 52
Source: Bloomberg 53
Yield to Maturity 2 Year Treasury Note 9/2004 9/2014 Source: Bloomberg 54
Agency to Treasury Relationship Bullet Agency Spreads to Treasuries 2 1.5 Mean:.30% Mean Excluding 1/2008-9/2009:.25% Current:.01% 1 0.5 0-0.5 Source: Bloomberg 55
Review your core competencies: Identify if you know how to do it, but you don t have time One of the biggest risks DUE DILIGENCE TIME Know what your capacity can handle Cover your basis Time is important Get done what you need to get done Identify the resources you need Know what you are capable of doing Note what you are missing Determine if you should seek other resources RESOURCES EXPERIENCE Know your comfort zone This is worth a lot-keep Calm and Carry On 56
BEST PRACTICE PROCESS 2014 and Beyond Best Practice Benchmark LIQUIDITY SAFETY RETURN Cash Flow Requirements Maintenance Diversification Quality Market Return Book Yield 57