Fitting Enhanced Cash Into Your Investment Management Process Presented By: Scott Prickett, CTP, Managing Director Portfolio Manager Patti Glock, Associate Vice President Client Services Manager

2 Outline The Current Environment Rate Levels Economy Labor Housing Consumer Government-Sponsored Enterprise-GSEs ~ (FNMA, FHLMC) The “Big Picture” Allocation of Your Operating Funds Tiers Historical Returns of Tier Groups Enhanced Cash Management Tools Summary

3 Market Dynamics and Rate Trends What is the market/economic environment right now? Interest Rate Trends Secular Perspective Analyze both long and short-term trends Investment Economics Monetary Policy Fiscal Policy Economic Indicators Labor Market Housing Consumer Sentiment

4 2 Year Treasury Historical Perspective

5 5 Year Historical U.S. Unemployment Rate

6 5 Year Historical Change in Non-Farm Payroll

7 5 Year S&P Case-Shiller 20 (YoY)

8 5 Year Housing Starts

9 5 Year Consumer Confidence (YoY)

10 GSE (Agency) Securities FNMA (Fannie Mae) and FHLMC (Freddie Mac) Recent Developments Outlook

11 The Big Picture Review investment statutes and solidify your investment policy. Establish broker/dealer guidelines and perform due diligence. Establish custody/safekeeping arrangements. Create a cash flow forecast. liquid funds and core funds. Identify liquid funds and core funds. (ALLOCATION) investment strategy Develop an investment strategy. (ALLOCATION) investment results Monitor the markets and investment results. (ALLOCATION) Stay disciplined but adjust when needed. Overview of the Operating Fund Investment Management Process

12 Considerations for the Long Term Allocation of Operating Funds Liquidity Allocation LGIPs MMFs (S&P rated LGIP Index and Merrill Lynch 0-3 Mo are commonly used benchmarks.) Enchanced Cash Allocation-Core Funds 60 Days-1 Yr WAM, Duration 2 Year Maximum Maturity (Merrill Lynch 0-1 Year T-Note Benchmark) Short Term Allocation-Core Funds 1 Yr-2 Yr WAM, Duration 3 Yr Maximum Maturity (Merrill Lynch 1-3 Yr Treasury Agency Benchmark) The average maturity (duration) of your operating portfolio is arguably the single greatest determinant of investment performance.

13 Operating Funds Can Be Allocated Into Different Tiers Each tier is distinct and can be benchmarked Short-Term Tier (1–3 Years) Enhanced Cash Tier (60 Days–1 Year) Liquidity Tier (0–60 Days, WAM) Jan Feb March April May June July Aug Sept Oct Nov Dec Core Funds  Enhanced Cash Tier  Short-Term Tier

14 Liquidity Allocation (Tier) Provides the highest degree of principal protection. Designed to provide perfect liquidity (constant NAV). Maintain balances at a level to provide for daily liquidity needs. Maintain an appropriate cushion (comfort level). Liquidity Tier (0-60 Days, WAM)

15 Short-Term Allocation (Tier) Designed for funds with holding periods of one to three years. Comes with a higher degree of principal volatility. Objective is to maximize returns. Yield and total return should be used when evaluating the short-term allocation tier. Historically a short-term portfolio allocation (Merrill Lynch 1-3 Year Treasury Index) has outperformed Money Market Funds (LGIP 30D Index) by 192 basis points over the past ten years. Short-Term Tier (1-3 Years)

16 Return Expectations: A Look at Historical Returns for Commonly Used Benchmarks MaturityDuration10 Years 5 Years1 Year 3 Month T-Bill S&P Rated LGIP Index (LGIP30D) Year T-Note (CMT) Merrill Lynch 0-1 Year Treasury Year T-Note (CMT) Merrill Lynch 1-3 Year Index December 31, 2009 Source: Bloomberg

17 Enhanced Cash Allocation (Tier) An enhanced cash strategy is designed to improve on returns provided by typical Money Market Funds and LGIPs while still meeting the primary goals of safety, of principal and liquidity. Historically an enhanced cash portfolio (Merrill Lynch 0-1 Year Note Index) has outperformed Money Market Funds (LGIP 30D Index) by 36 basis points over the past ten years. Total return and yield should be used when evaluating enhanced cash strategies. A longer duration results in slightly higher principal (price) volatility. Enhanced Cash Tier (60 Days – 1 Year)

18 Enhanced Cash Allocation (Tier) There is no industry recognized standard definition of Enhanced Cash Funds (maturities as well as credit quality may vary). Typical duration (WAM) range is 6 Months to 1 Year with a maximum maturity of 2 Years. Historically, incremental risk vs. the increase in returns is very low. Enhanced Cash Tier (60 days -1 Year)

19 Enhanced Cash Characteristics Position vs. LGIPs/MMFs and Short-Term Portfolios LGIP/MMF Enhanced Cash Short-Term Bond Common Target Portfolio Duration 0-60 Days 6 Months To 1 Year Years Eligible Investments 2a-7Statute/Policy Maximum Maturity 13 Months2 Years5 Years Commonly Used Benchmark LGIP 30 Day Or 3 Mo T-Bill 0-1 Year Index1-3 Years Risk

20 Why Benchmark Short-Term Cash Portfolios? The assessment of risk and return expectations Determination of opportunity costs Evaluate Investment Strategy Allows performance attribution to Yield Curve Positioning Sector Selection Credit Decisions Communication of Variation from Benchmark/Strategy Benchmark Selection Criteria Reflective of liquidity needs and risk tolerance Similar duration as portfolio Should have similar credit quality and eligible instruments Consistently calculated and will most often be obtained from a third party

21 Performance Benefits for an Enhanced Cash Allocation Strategy Example #1 YearS&P AAA rated LGIP 30D Index EarningsBlended LGIP & 0-1 Year Treasury Return EarningsEarnings Difference %$1,505, %$1,581,050$76, %$1,025, %$1,206,500$181, %$412, %$497,550$85, %$242, % $288,850$46, %$280, %$286,450$6, %$727, %$717,300$(10,200) %$1,187, %$1,177,000$(10,500) %$1,255, %$1,319,050$64, %$655, %$763,750$108, %$127, %$124,050$(3,450) 10 Yr Cum2.97%$7,417, %$7,961,550$544,050 $25 Million Total Fund Investment Balance Blended Percentage Based upon 40% LGIP, 60 % Merrill 0-1 Year Agency Index

22 Performance Benefits for an Enhanced Cash Allocation Strategy Example #2 $25 Million Total Fund Investment balance Blended Percentage Based upon 40% LGIP, 30 % 1 Year Treasuries, 30% Merrill 1-3 Year Agency Index YearS&P AAA rated LGIP 30D Index EarningsBlended LGIP, 1 Yr Treas. & 1-3 Yr Agency Return EarningsEarnings Difference %$1,505, %$1,732,325$227, %$1,025, %$1,455,875$430, %$412, %$789,600$377, %$242, % $356,725$114, %$280, %$287,950$7, %$727, %$636,675$(90,825) %$1,187, %$1,164,625$(22,875) %$1,255, %$1,415,650$160, %$655, %$1,041,850$386, %$127, %$249,975$122, Yr Cum2.97%$7,417, %$9,131,250$1,713,750

23 Risk/Return Profile of the 3 Tiers Source: Bloomberg – Merrill Lynch Index Extending the term can add performance but also additional risk. Risk/Return of Treasury Benchmarks 10 Years Ended 12/31/09 IndexDurationOverall Return Quarters With Negative Returns S&P Rated LGIP Index %0 of Year Treasury Index %0 of Year Treasury Index %4 of Year Treasury Index %14 of 40 Short-term portfolios minimize risk at the expense of return. Longer-term portfolios provide significant risks with marginal gain. Average 10 Year historical yield for the 2 Year Treasury = 3.26%. Average 10 Year historical yield for the 5 Year Treasury = 3.99%.

24 Management Tools Enhanced Cash Portfolios Yield Curve Analysis Spread Analysis GAP Analysis Credit Analysis Security Selection

25 Yield Curve and Spread Analysis Review of Basic Curve Types Recent Yield Curve Trends Analyze Specific Sector of the Yield Curve Analyze Yield Curve for the Specific Security Example of GAP (Breakeven) Analysis Spread Analysis

26 Review of Basic Curve Types Positive or “Normal” Flat Inverted

27 Historical Yield Curve

28 Spread Analysis A systematic comparison of alternative securities. Helps quantify investment decisions. Spread analysis is not one dimensional. Within market sectors Between market sectors

29 Money Market Curves &Yield Spreads

30 U.S. Treasury vs. Agencies

31 Securities Specific Spread Analysis Relative Value

GAP (Breakeven) Analysis Two Examples

33 GAP Analysis GAP Analysis is a mathematical way to evaluate short-term strategies on a BREAKEVEN basis. GAP Analysis compares two short-term investments VERSUS an equivalent longer term investment.

34 GAP Analysis Examples Option A: On September 10, 2010 you have the opportunity to buy a 14-month Agency Security yielding 0.35%. Option B: On September 10, 2010 you buy a 6-Month Agency Security yielding 0.21% and a 2 nd 8-Month Agency when the 1 st matures. Calculate the rate you need to earn from the 2 nd Agency security to break even. (Make up the yield difference.)

35 GAP Analysis 1 st Example 0.35% 0.21%? (Head = 178 Days)(Tail = 261 Days) Sept 10, 2010 March 7, 2011Nov 23, 2011 (Full Term = 439)

36 GAP Analysis Example #1 (Bloomberg)

37 GAP Analysis 1 st Example 0.35% 0.21%0.65% (Head = 178 Days)(Tail = 261 Days) Sept 10, 2010 March 7, 2011Nov 23, 2011 (Full Term = 439)

38 GAP Analysis 2nd Example 0.72% 0.35%? (Head = 439 Days)(Tail = 305 Days) Sept 10, 2010 Nov 23, 2011Sept 23, 2012 (Full Term = 744)

39 GAP Analysis Example #2 (Bloomberg)

40 GAP Analysis 2nd Example 0.72% 0.35%1.25% (Head = 439 Days)(Tail = 305 Days) Sept 10, 2010 Nov 23, 2011Sept 23, 2012 (Full Term = 744)

41 Portfolio Management Summary Review Recent Yield Curve Trends. Analyze the Specific Portion of Curve you are Interested in. Analyze Curve for Specific Maturity. Use Spread Analysis to Compare Alternative Securities. Use Gap Breakeven Analysis When Applicable.

42 Summary Enhanced cash and or short-term allocation strategies are not designed to replace Money Market Funds. Should be used to supplement an investor’s cash allocation to facilitate the pursuit of higher returns over time without sacrificing safety of principal or liquidity. Inefficiencies embedded in the yield curve and security selection strategies provide the opportunity to be competitive with assigned benchmarks. A combination of two or all three of these strategies, matching different liquidity and risk tolerance tiers can provide significant increases in the performance of your short-term funds. The average maturity (duration) of your operating fund portfolio is arguably the single greatest determinant of investment performance.