Fitting Enhanced Cash Into Your Investment Management Process

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Fitting Enhanced Cash Into Your Investment
Management Process

• Presented ByScott Prickett, CTP, Managing
  Director
• Portfolio Manager
• Patti Glock, Associate Vice President
• Client Services Manager

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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

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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

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2 Year Treasury Historical Perspective
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5 Year Historical U.S. Unemployment Rate
6
5 Year HistoricalChange in Non-Farm Payroll
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5 Year SP Case-Shiller 20 (YoY)
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5 Year Housing Starts
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5 Year Consumer Confidence (YoY)
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GSE (Agency) Securities

• FNMA (Fannie Mae) and FHLMC (Freddie Mac)
• Recent Developments
• Outlook

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The Big Picture
Overview of the Operating Fund Investment
Management Process

• 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.
• Identify liquid funds and core funds.
  (ALLOCATION)
• Develop an investment strategy. (ALLOCATION)
• Monitor the markets and investment results.
  (ALLOCATION)
• Stay disciplined but adjust when needed.

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Considerations for the Long Term Allocation of
Operating Funds

• Liquidity Allocation
• LGIPs
• MMFs
• (SP 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.

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Operating Funds Can Be AllocatedInto Different
Tiers

• Core Funds
• Enhanced Cash Tier
• Short-Term Tier

• Each tier is distinct and can be benchmarked

Liquidity Tier (060 Days, WAM)
Enhanced Cash Tier (60 Days1 Year)
Short-Term Tier (13 Years)
Jan Feb March April May June
July Aug Sept Oct Nov Dec
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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)
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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)
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Return Expectations A Look at Historical Returns
for Commonly Used Benchmarks
December 31, 2009
Maturity Duration 10 Years 5 Years 1 Year
3 Month T-Bill .25 2.75 2.83 0.14
SP Rated LGIP Index (LGIP30D) .16 2.97 3.16 0.51

1 Year T-Note (CMT) .95 3.03 3.07 0.47
Merrill Lynch 0-1 Year Treasury .51 3.33 3.36 0.49

2 Year T-Note (CMT) 1.94 3.30 3.19 0.95
Merrill Lynch 1-3 Year Index 1.88 4.89 4.45 2.17
Source Bloomberg
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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)
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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)
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Enhanced Cash Characteristics
Position vs. LGIPs/MMFs and Short-Term Portfolios
Risk
LGIP/MMF Enhanced Cash Short-Term Bond
Common Target Portfolio Duration 0-60 Days 6 Months To 1 Year 1.5 - 2 Years
Eligible Investments 2a-7 Statute/Policy Statute/Policy
Maximum Maturity 13 Months 2 Years 5 Years
Commonly Used Benchmark LGIP 30 Day Or 3 Mo T-Bill 0-1 Year Index 1-3 Years
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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

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Performance Benefits for an Enhanced Cash
Allocation Strategy Example 1

• 25 Million Total Fund Investment Balance
• Blended Percentage Based upon 40 LGIP, 60
  Merrill 0-1 Year Agency Index

Year SP AAA rated LGIP 30D Index Earnings Blended LGIP 0-1 Year Treasury Return Earnings Earnings Difference
2000 6.02 1,505,000 6.32 1,581,050 76,050
2001 4.10 1,025,000 4.83 1,206,500 181,500
2002 1.65 412,500 1.99 497,550 85,050
2003 .97 242,500 1.16 288,850 46,350
2004 1.12 280,000 1.15 286,450 6,450
2005 2.91 727,500 2.87 717,300 (10,200)
2006 4.75 1,187,500 4.71 1,177,000 (10,500)
2007 5.02 1,255,000 5.28 1,319,050 64,050
2008 2.62 655,000 3.06 763,750 108,750
2009 .51 127,500 0.50 124,050 (3,450)
10 Yr Cum 2.97 7,417,500 3.18 7,961,550 544,050
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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

Year SP AAA rated LGIP 30D Index Earnings Blended LGIP, 1 Yr Treas. 1-3 Yr Agency Return Earnings Earnings Difference
2000 6.02 1,505,000 6.93 1,732,325 227,325
2001 4.10 1,025,000 5.82 1,455,875 430,875
2002 1.65 412,500 3.16 789,600 377,100
2003 .97 242,500 1.43 356,725 114,225
2004 1.12 280,000 1.15 287,950 7,950
2005 2.91 727,500 2.55 636,675 (90,825)
2006 4.75 1,187,500 4.66 1,164,625 (22,875)
2007 5.02 1,255,000 5.66 1,415,650 160,650
2008 2.62 655,000 4.17 1,041,850 386,850
2009 .51 127,500 1.00 249,975 122,475
10 Yr Cum 2.97 7,417,500 3.65 9,131,250 1,713,750
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Risk/Return Profile of the 3 Tiers

• Extending the term can add performance but also
  additional risk.

Risk/Return of Treasury Benchmarks 10 Years Ended 12/31/09 Risk/Return of Treasury Benchmarks 10 Years Ended 12/31/09 Risk/Return of Treasury Benchmarks 10 Years Ended 12/31/09 Risk/Return of Treasury Benchmarks 10 Years Ended 12/31/09
Index Duration Overall Return Quarters With Negative Returns
SP Rated LGIP Index .18 2.96 0 of 40
0-1 Year Treasury Index .51 3.30 0 of 40
1-3 Year Treasury Index 1.72 4.47 4 of 40
3-5 Year Treasury Index 3.80 6.00 14 of 40
Source Bloomberg Merrill Lynch Index

• 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.

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Management Tools Enhanced Cash Portfolios

• Yield Curve Analysis
• Spread Analysis
• GAP Analysis
• Credit Analysis
• Security Selection

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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

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Review of Basic Curve Types
Positive or Normal
Flat
Inverted
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Historical Yield Curve
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Spread Analysis

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

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Money Market Curves Yield Spreads
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U.S. Treasury vs. Agencies
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Securities Specific Spread AnalysisRelative Value
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GAP (Breakeven) Analysis
Two Examples
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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.

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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 2nd 8-Month Agency
  when the 1st matures.
• Calculate the rate you need to earn from the 2nd
  Agency security to break even. (Make up the
  yield difference.)

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GAP Analysis 1st Example
0.35
(Full Term 439)
0.21
?
(Head 178 Days)
(Tail 261 Days)
Sept 10, 2010
March 7, 2011
Nov 23, 2011
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GAP Analysis Example 1 (Bloomberg)
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GAP Analysis 1st Example
0.35
(Full Term 439)
0.21
0.65
(Head 178 Days)
(Tail 261 Days)
Sept 10, 2010
March 7, 2011
Nov 23, 2011
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GAP Analysis 2nd Example
0.72
(Full Term 744)
0.35
?
(Head 439 Days)
(Tail 305 Days)
Sept 10, 2010
Nov 23, 2011
Sept 23, 2012
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GAP Analysis Example 2(Bloomberg)
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GAP Analysis 2nd Example
0.72
(Full Term 744)
0.35
1.25
(Head 439 Days)
(Tail 305 Days)
Sept 10, 2010
Nov 23, 2011
Sept 23, 2012
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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.

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Summary

• Enhanced cash and or short-term allocation
  strategies are not designed to replace Money
  Market Funds.
• Should be used to supplement an investors 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.