A Presentation to the

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Investment Policy and Asset Allocation
A Presentation to the Alaska Government Finance
Officers Association
April 19, 2006 Jeff Pantages,CFA CIO, APCM

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Agenda

• Investment Policy Considerations
• GFOA Sample Policy
• GFOA Best Practices
• APCM Best Practices
• Asset Allocation
• Short term operating funds (preservation of
  capital)
• Longer term invested assets (balance risk and
  return)

Short term operating funds
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Agenda

• Appendix
• GFOA Sample Investment Policy
• Public Investor Portfolio Strategies
• APCM TANSTAAFL
• Investinginbonds.com
• Moody Commercial Paper Summary

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GFOA Sample Investment Policy

• General Objectives
• Safety, Liquidity, Yield
• Standard of Care
• Prudent Person
• Ethics, Conflicts, Disclosure
• Delegation of Authority
• Safekeeping Custody
• Authorized Financial Dealers (Alaska preference?)
• Internal Controls
• Delivery vs. Payment

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GFOA Sample Investment Policy

• Suitable Authorized Investment
• Investment Types
• Collateralization and Repo Agreements
• Investment Parameters
• Diversification Concentration Risk
• Maximum Maturity Limitations
• Reporting
• Current Holdings Transactions at Least
  Quarterly
• Performance Standards
• Marking to Market

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GFOA Sample Investment Policy

• List of Attachments
• Authorized Personnel
• Investment Statutes/Ordinances
• Repo Agreements
• Authorized Dealers
• Credit Analysis of Holdings
• Safekeeping Agreements
• Methodology for Calculating Returns

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GFOA Best Practices

• Repurchase Agreements
• Counterparty exposure. Custodian. Tri-party
  Agreement. 102 haircut. Acceptable securities.
  Reverse repos should not be used for leverage.
  (Orange County!) Valuation of collateral on daily
  basis, or at least weekly.
• Mutual Funds
• Diversification, liquidity, professional
  management.
• Track record. Expenses. Portfolio composition.
• Dealer Relationships
• Competitive bidding. Dealers to acknowledge
  receipt of government entitys investment policy.

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GFOA Best Practices

• Using Cash Flow Forecasts
• Organizational level. Use historical data.
  Prioritize items. Discretionary vs. Mandatory.
• Market Risk Ratings
• Not credit risk, but CMO volatility risk. Run
  FFIEC test on Bloomberg.

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GFOA Best Practices
Support Tranche CMO Yields 7.77 with 1.1 Year
Average Life!
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• Use of Derivatives
• Use extreme caution. Can be volatile, illiquid,
  and highly leveraged. Is
• broker an agent or proprietary position?

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APCM Best Practices

• Higher Quality
• SLY, of course. A or better. A1/P1. Shorter
  maturities.
• Diversification
• Andrew Carnegie was wrong! Maximum 1-5 per
  issuer.
• Measure Performance
• If you keep the score, youll know the score, and
  the score will improve. Mark to Market. Choose a
  benchmark.
• Market quotes securities in yield
• But makes money in dollars and sense.
• Total return vs. yield.

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Callables Trade on an OAS Basis!
This Agency bond yields 32.5 bp more than
Treasuries, But only 20.72 bp once we adjust for
its call feature. This is less than
non-callable, bullet, Agency paper!
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Bond Market Historical Returns
Over longer time periods intermediates (3-7
years) beat Money Markets (T-bills)
annualized returns
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APCM Best Practices

• Determine true liquidity needs
• Many SLG own Treasuries/Agencies only
• A bond is not a person!
• Trust, but Verify!
• Sunshine. Demand Transparency. This aint
  church. Internal and external checks.
• Competition is a wonderful thing
• For investment bankers, brokers, and investment
  managers
• Best price and execution

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Electronic Trading (14 Dealers!) Better
Pricing/Faster
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TRACE Shows Inefficient Pricing!
Look at Reference Spread to Treasuries (RefSP)
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Asset Allocation for Short Term Operating Funds
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Asset Allocation for Short Term Operating Funds

• A Variety of Approaches
• Active Management vs. Passive Buy and Hold
• Bullets, barbells, and ladders
• Riding the yield curve
• Yield tilt in credit or optionality
• General Fund Pool
• Short term cyclical needs suggest cash matching,
  SLY
• Bond Proceeds
• Cash matching to construction schedule (false
  precision?)

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Asset Allocation for Short Term Operating Funds

• Reserve Accounts
• Debt serve reserve, SLY but invest longer term.
• Operating cushion/surplus funds, passive
  core/active satellite.
• Permanent Funds
• Longer holding period allows for riskier
  assets.
• Are stocks risky? Depends on time horizon!
• Downside risks decrease with time.

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Common Stock Returns

• As time horizon extends, odds of positive returns
  goes up!
• Time diversification smoothes the ride!
• Diversification into other asset classes improves
  results!

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Asset Allocation for Long Term Invested Assets
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Asset Allocation

• What is Asset Allocation?
• Asset allocation is the process of determining
  the optimal allocation among different asset
  classes such as stocks, bonds, and cash in a
  portfolio.

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Asset Allocation

• Importance of Asset Allocation
• Several studies report that asset allocation may
  account for more than 90 of the return of a
  portfolio
• The initial strategic allocation among asset
  classes is more important than choosing the
  actual stocks and bonds that you will own
• 1)Brinson, Hood, and Beebower (1986) and
  Brinson, Singer, and Beebower (1991),
  Ibbotson/Kaplan (2000) offer statistical evidence
  for the importance of asset allocation.

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Risk/Reward Tradeoff
Asset Allocation

• Low levels of uncertainty (low risk) are
  associated with low potential returns and high
  levels of uncertainty (high risk) are associated
  with high potential returns

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Asset Allocation
What is Risk?

• Probability of loss or injury also
  uncertainty
• Statisticians capture investment risk as the
  volatility of returns or standard deviation
• Treasury bills have a very low standard
  deviation, while stocks have a much higher
  standard deviation

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Asset Allocation
Risk and Return from 1926 - 2005
The 1933 Small Company Stocks Total Return was
142.9 percent.
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Asset Allocation

• Diversification is Key
• We can improve the risk/reward tradeoff via
  diversification
• Combining assets that do not move up or down in
  tandem that have a low correlation improves
  diversification
• Assets that move together have a high correlation
  and do not improve portfolio diversification
• Dont put all your eggs in one basket

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Asset Allocation
This chart illustrates two hypothetical
investments in different markets which fluctuate
in opposition when investment A is up,
investment B is down. The investor who owns both
evens out investment results.
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Asset Allocation
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Asset Allocation
Efficient Portfolio Construction

• Identify asset classes and determine expected
  return, risk, and correlation among them
• Use optimization model to identify efficient
  combinations of assets portfolios that
  maximize expected return for given risk level
• These portfolios make up the efficient frontier
  and investors should be on it
• Determine which position on the efficient
  frontier is consistent with client return
  aspirations, tolerance for risk, and time horizon

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Efficient FrontierPortfolio Optimization
Asset Allocation

• Optimization is the process of identifying
  portfolios that have the highest possible
  expected return for a given risk level
• Such a portfolio is considered efficient, and
  the locus of all efficient portfolios is called
  the efficient frontier

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Asset Allocation
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Asset Allocation
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Asset Allocation
3 Sample Allocations (portfolio )
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Asset Allocation
But Where on the Efficient Frontier?

• Client risk tolerances, return aspirations, and
  constituent demands
• Exam various return/risk combinations
• Utilize Monet Carlo Simulation to understand
  downside risks (5th percentile)

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Asset Allocation
Monte Carlo Simulation

• Monte Carlo, Monaco gambling capital of Europe!
• Run 2000 simulations to develop probability
  distribution of results for each portfolio
• Answers questions like how many times out of
  these 2000 scenarios did I reach my goal?
• The distribution of outcomes (arrayed in
  percentiles) can be used to evaluate and
  identify the appropriate asset allocation policy

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Asset Allocation (Monte Carlo Simulation)
Return Percentiles (over 1,5,10 years)
Wealth Percentiles (over 1,5,10 years)
Note 100 Million Portfolio
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Asset Allocation (Monte Carlo Simulation)
Wealth Percentiles
Note 100 Million Portfolio
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Asset Allocation (Monte Carlo Simulation)
100 Million
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Asset Allocation
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Asset Allocation
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Questions