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

Why Benchmark Your Portfolio?

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

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

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

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?

Performance Measurement

Measuring Return There are two different prospectives: Yield Approach 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

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

Yield to Maturity

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

Yield to Call

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

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

Total Return vs. Yield to Maturity (YTM)

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

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

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

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

Selecting a Benchmark For Your Core Portfolio

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

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

Duration Effect - Risk/Return Tradeoff

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

Amortized Cost – Evaluating Market Risk

Amortized Cost – Evaluating Market Risk 06/30/10 Final Effective Weighted Issuer / Maturity Call Date Acquisition % of Days to Wtd. Avg. Average Security Coupon Date (if any) Cost Portfolio Call YTM Yield FNMA POOL 5.000% 11/01/10   $ 1,438,167.80 2.68% 124 0.308% 3.33 0.008% 4.000% 12/01/10 $ 1,326,607.49 2.48% 154 0.164% 3.81 0.004% 4.500% 01/01/11 $ 1,630,747.40 2.30% 185 0.412% 4.25 0.009% 06/01/11 $ 2,077,436.49 3.88% 336 0.667% 13.02 0.026% FNMA 2.000% 08/12/13 08/12/10 $ 997,500.00 1.86% 1139 43 2.074% 21.20 0.80 0.039% FHLB 1.000% 05/26/15 11/26/10 $ 1,000,000.00 1.87% 1791 149 33.42 2.78 0.019% 12/30/15 12/30/10 2009 183 37.48 3.41 0.037% 4.100% 07/01/16 07/01/10 $ 1,012,434.23 1.89% 2193 1 3.889% 41.43 0.02 0.073% 2.530% 05/04/17 08/04/10 2500 35 46.65 0.65 0.047% FHLMC 3.100% 05/19/17 2515 46.93 0.058% 11/27/17 2707 50.51 12/18/17 09/18/10 $ 747,000.00 1.39% 2728 80 38.02 1.12 0.028% 3.000% 01/29/18 07/29/10 2770 29 51.68 0.54 0.056% 02/12/18 2784 51.95 2.500% 12/23/19 09/23/10 3463 85 64.61 1.59 02/24/20 02/24/11 3526 239 65.79 4.46 05/19/20 11/19/10 3611 142 67.38 2.65 06/16/20 06/16/11 3639 351 67.90 6.55 FHLMC POOL 6.000% 09/01/21 $ 1,313,080.36 2.45% 4081 4.945% 99.98 0.121% 02/25/22 08/25/10 4258 56 79.45 1.04 0.075% 05/28/24 08/28/10 $ 965,000.00 1.80% 5081 59 4.320% 91.49 1.06 0.078% 5.125% 08/19/24 $ 478,514.06 0.89% 5164 4.848% 46.11 0.043% 09/30/24 09/30/10 5206 92 97.14 1.72 02/02/25 5331 99.47 CD 12/28/10 $ 14,000,000.00 26.12% 181 2.650% 47.28 0.692% Money Market $ 13,594,074.82 25.36% 0.210% 0.25 0.053% Totals $ 53,594,961.99 100.00% 1271.94 346.90 1.850% Loss to effective 2.85% Loss to final 10.45% Given a 300 basis point increase in rates.

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

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

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

How to Communicate Using Benchmarks

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 Need to swap out with Q1 charts

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