Managing Portfolios Without Getting in Over Your Head © Chandler Asset Management, Inc. Kay Chandler, CFA President, Chandler Asset Management April 26, 2006

2 The TopicInvestment Ideas for Smaller Portfolios Smaller? Fewer Resources

3 A Comparison City of Los Angeles $5 billion + Treasurer CIO 3 PMs Active strategies Daily Trading A Medium-sized City $300 million Finance Director Treas…

4 Small vs. Large Portfolios? More vs. fewer available staff Budget for portfolio management resources, e.g., Bloomberg, BondEdge, independent credit research Ability to provide continuity of program management

5 Regardless of Portfolio Size and Available Resources Safetymaintain appropriate level of exposure to risk Liquidity Sufficient short-term investments Marketable securities Targeted maturities Extra layer Yield (Return,Growth) Income Long-term growth

6 Every Portfolio Needs an Overriding Strategy When resources for management are scarce Long-term strategy must predominate Passive strategies may be preferred Eliminate short-term trading Minimize interest rate forecasting Hold to maturity Risk management may look quite different

7 Portfolio Management Is Risk Management The greater an investors exposure to properly diversified risk, the higher the expected return over time. The greater an investors exposure to risk, the higher will be the volatility of return from period to period. The objective of safety requires establishing risk constraints.

8 Tips for Managing Risk Market Risk Liquidity risk Reinvestment risk (Callables) Credit Risk (Non-governmental Issuers) Otherpolitical, job, etc.

9 Exposure To Interest Rate FluctuationsMarket Risk Market risk Securities prices change as interest rates changein the opposite direction Market risk is best measured as modified duration Measure effective duration instead when securities have a call feature

10 What Is Duration, Anyway? Modified duration measures the percent change in price of a security for a 1 percent change in yields. Since market prices decline when yields rise, and rise when yields decline, duration is multiplied by –1 and then multiplied by the change in yield. We cant predict interest rates, but, using duration, we can calculate exactly how much the portfolio market value will change with a given, instantaneous change in interest rates

11 What Is Duration, Anyway? Portfolio size = $50 million Portfolio duration = 2 Interest rate Δ = +2.25% Portfolio MV Δ = $50 million x 2 x 2.25% x -1 MV Δ = ($2,250,000) Interest rate Δ = -2.25% Portfolio MV Δ = $50 million x 2 x (2.25%) x -1 MV Δ = +$2,250,000 Portfolio size = $50 million Portfolio duration = 1 Interest rate Δ = +2.25% Portfolio MV Δ = $50 million x 1 x 2.25% x -1 MV Δ = ($1,125,000) Interest rate Δ = -2.25% Portfolio MV Δ = $50 million x 1 x (2.25%) x -1 MV Δ = +$1,125,000

12 An Aside Regarding Interest Rate Forecasting Can all the following be forecast in a way that results in superior performance? Direction Magnitude Timing FRB St. Louis: Professional forecasters do not outperform random walk The longer the horizon, the worse the error statistics

13 Greater Exposure To Market Risk Leads To Higher Return Over Time

14 Greater Exposure To Market Risk Means Higher Volatility Higher Duration Portfolios Have Greater Volatility of Return LAIF is a LGIP managed by the California State Treasurer for California local agencies which invests primarily in short-term securities and seeks to pay $1 dollar out for every $1 dollar invested. The 1-3 Year and the 1-5 Year benchmarks are unmanaged index portfolios with durations of _____ and ______ respectively as of 12/31/05..

15 Laddering Can Be a Substitute for Targeting Duration Stagger maturities evenly to desired final maturity Short-term investments sufficient to meet cash needs When ladder securities mature, roll the funds out to the end of the ladder Collect the interest and wait for maturities

16 Managing Liquidity Risk Liquidity risk (2 definitions) 1. The risk that the portfolio wont provide adequate cashflow for the agency 2. The risk that a security cant be sold, if necessary, at a good price Measured by such factors as the difference between bid and ask and the number of market makers for the issue This definition is not so important for passive investors

17 Managing Liquidity Risk Determine short-term investment needs through cash flow forecasting and other techniques Maintain sufficient investments in vehicles such as LAIF, money market funds, individual short- term securities Invest remainder in strategies with higher expected yields Definition 1

18 Reinvestment risk: cashflows from a bond must be reinvested at the market rate at the time the cashflow occurs Interest payments Paydowns from mortgage securities Principal from called bonds Reinvestment Risk

19 Value in Callable Securities In a period of falling rates, bullet securities, with higher duration and positive convexity, provide more growth than callables. But when rates are stable or rising, callables, with their generally higher coupons, tend to outperform bullets, especially after the initial duration extension is complete.

20 Risk in Callable Securities The investor takes on the risk of a long-term security, but may end up without the reward Callable securities are difficult to value, since the duration is ultimately unknowable Cash flows are uncertainin a way that works against the investor

21 Credit Riskthe Opportunity Assuming additional credit risk should result in higher returns over time With a similar pattern of volatility of return

22 Assuming credit risk requires that additional resources be devoted to the investment program Moodys/S&P ratings, watch lists, outlook At time of purchase and On a regular basis Supplemented by Third party sources Internally generated credit research Credit Riskthe Tradeoff

23 Outsourcing The Investment Management Function to an Adviser An investment firm with demonstrated expertise in the management of investment portfolios Acts as a fiduciary for client assets Registered with and regulated by the SEC under the Investment Advisers Act of 1940 Compensated on the basis of assets under management, not transactions

24 Benefits of Using an Adviser Enhanced returns net of fees Reduced risk Better informationreporting, program evaluation Internal staff free to perform other duties

25 Are There Any Risks? Third party custodian is essentialan outside adviser should never have custody of assets The client must monitor Compliance with Government Code Compliance with Policy Performance relative to appropriate benchmarks

26 Enjoy the Benefits, Manage the Risks Cash is kingsufficient short term investments to meet expected, and even some unexpected, requirements Exposure to market risk through laddering in all market environments Do you have sufficient resources to analyze and monitor credit risk An outside investment adviser can bring expertise to portfolio structuring and risk management at a reasonable cost