investment policy and asset allocation …asset allocation short term operating funds (preservation...

T R U S T E D A D V I S O R S ▪ M O R E E X P E R T S ▪ B E T T E R A C C E S S

INVESTMENT POLICY AND ASSET ALLOCATION FOR LOCAL GOVERNMENTS

Alaska Municipal League

Agenda

Investment Policy Considerations

Sample Policy

Best Practices

Asset Allocation

Short term operating funds (preservation of capital)

Longer term invested assets (balance risk and return)

T R U S T E D A D V I S O R S ▪ M O R E E X P E R T S ▪ B E T T E R A C C E S S 1

Sample Investment Policy

General Objectives Safety, Liquidity, Yield or Maintain purchasing power of the portfolio over time and pay out

4% annually*

Standard of Care Prudent Person Ethics, Conflicts, Disclosure Delegation of Authority (don’t abdicate!)

Safekeeping & Custody Separate from the investment function Internal Controls Delivery vs. Payment


*APCM


Suitable & Authorized Investment

Investment Types

Collateralization and Repo Agreements

Investment Parameters

Diversification & Concentration Risk

Maximum Maturity Limitations

Reporting

Performance Standards (choose a benchmark)

Current Holdings & Transactions at Least Quarterly


Investment Report Including

An asset listing showing a description of each security including par value, cost and market value

Average maturity and modified duration of the portfolio

Maturity distribution of the portfolio

Average portfolio credit quality and yield vs. Benchmark

Total rate of return for the portfolio for the prior one month, three months, twelve months, year to date, and since inception compared to the Benchmark Index.

Distribution by type of investment



List of Attachments

Authorized Personnel

Investment Statutes/Ordinances

Repo Agreements

Authorized Dealers

Credit Analysis of Holdings

Safekeeping Agreements

Methodology for Calculating Returns


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 Dealers to acknowledge receipt of government entity’s

investment policy. Competitive bidding. Trust but verify.


How can I help you Mrs. Investor?


Best Practices

Hiring an Advisor

Expertise, complements internal resources, access to markets, economies of scale

Examine track record – apples to apples comparisons

Require a face to face interview

Check fees – separate account or commingled fund?


In Ancient Times…


10 Minutes per Trade. 3 Dealers by Phone.

Now Via Electronic Platforms…


Trade in 15 Seconds. 8 Dealers Simultaneously Through the Web.

Electronic Trading (13 Dealers!) = Better Pricing/Faster


APCM Best Practices

Determine True Liquidity Needs

Many LGs own Treasuries/Agencies only

A bond is not a person!

Price stability or income stability

Use of Derivatives

Futures, Options, and Swaps


Warning: Products

can be volatile,

illiquid, and

highly leveraged.

Derivatives: Use EXTREME CAUTION.


Yield Curve: June 2007 vs. September 2014


What are you worried about? Income or price stability?

Bond Market Historical Returns


4.3% 4.5%

5.6% 5.0%

1.1% 0.9%

2.5%

3.7%

0.1% 0.1% 0.1%

1.7%

0%

2%

4%

6%

8%

1 Year 3 Years 5 Years 10 Years

Intermediates Beat T-bills

U.S. Intermediate Corporates U.S. Intermediate Governments U.S. T-bills

Data: Barclays Indices as of September 30, 2014

Interest Rates and Inflation Near Historic Lows


Source: FRB of St. Louis. Shaded areas indicate U.S. recessions.

Inflation: +1.5% PCE Core – Year over Year

10 Year Treasury: 2.49% as of September 30, 2014

+8.4%: Annualized Total Return on U.S. Aggregate Bonds from 1981 to 2014

Total Return in a Rising Rate Environment


Return Over 1 Year Time Horizon +100 Basis Points +200 Basis Points

3 Month T-bill (0.02%) +0.37% +0.62%

1 Year Treasury (0.11%) +0.11% +0.11%

3 Year Treasury (0.77%) -1.17% -3.08%

5 Year Treasury (1.41%) -2.30% -5.93%

10 Year Treasury (2.19%) -5.43% -12.65%

Data: Bloomberg as of October 20, 2014

Asset Allocation for Short Term Operating Funds


Asset Allocation: 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?)



Reserve Accounts

Debt serve reserve, SLY but invest longer term

Operating cushion/surplus funds

Permanent Funds

Longer holding period allows for “riskier” assets

Are stocks risky? Depends on time horizon!

Downside risks decrease with time




Retu

rn (%

)

Liquid Cash

Enhanced Cash

Short -Term Cash

Corporate Notes

Taxable Municipals

Certificate of Deposits

Repos (Collateralized)

U.S. Gov Agencies

U.S. Treasuries

More Liquidity Less

Commercial Paper Bankers Acceptances Certificate of Deposits LGIP’s and MMF’s Repos (Collateralized) U.S. Gov Agencies U.S. Treasuries

Asset Backed Securities

Mortgage Backed Securities

Corporate Notes

Taxable Municipals

Certificates of Deposit

U.S. Gov. Agencies

U.S. Treasuries

Risk

Portfolio Allocations by Time Horizon

General Fund Bond Proceeds/ Reserve Accounts

Source: Prepared by Florida Management and Administrative Services, Orlando, Florida, For Discussion Purposes.

Common Stock Returns

As time horizon extends, odds of positive returns go up!

Time diversification smooths the ride!

Diversification into other asset classes improves results!


Rolling Time Periods (U.S. Large Stocks 1926 - 2011)

Lowest Returns Highest Returns % Times Positive

1-Year Rolling -43.3% 54.0% 72.1%

5-Year Rolling -12.5% 28.6% 85.4%

10-Year Rolling -1.4% 20.1% 94.8%

20-Year Rolling 3.1% 17.9% 100.0%

Stock Returns by Decade


19.2

-0.1

9.2

19.4

7.85.9

17.6 18.2

-0.9

-5

0

5

10

15

20

25

1920's 1930's 1940's 1950's 1960's 1970's 1980's 1990's 2000's

Perc

ent A

nnua

l Ret

urn

(%)

Average = 9.8%

Data: Ibbotson

Diversified Returns in the Oughts (2000’s)


Annualized Returns - January 1, 2000 to December 31, 2009

5.4%4.7%

3.1%

0%1%2%3%4%5%6%

Annu

alize

d Re

turn

70% Bonds 30% Stocks



Inflation

Asset Allocation for Long Term Invested Assets


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.


Asset Allocation Principals


Several studies report

that asset allocation may account for more than 90% of the return of a portfolio compared to the policy portfolio*

The initial strategic allocation among asset classes is more important than choosing the actual stocks and bonds that you will own

* Brinson, Hood, and Beebower (1986) and Brinson, Singer, and Beebower (1991), Ibbotson/Kaplan (2000) offer statistical evidence for the importance of asset allocation.

Importance of Asset Allocation

Asset Allocation

90%

Security Selection and

Timing10%

Asset Allocation Principals


Source: Prudent Practices for Investment Stewards by Fiduciary360 (2008)

Many investment committees spend far too much time on activities that often subtract value—such as manager selection and market timing—and not enough time on establishing and adhering to their asset-allocation targets, where their efforts could really add value.

Endowment Management: A Practical Guide (2004) - Page 26

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

“Don’t put all your eggs in one basket”


Asset Allocation


This chart illustrates two different investments which have negative correlation. When investment A is up, investment B is down and visa versa. The investor who owns both evens out investment results.

Asset Classes


Bonds Stocks Alternatives

U.S. Investment Grade

U.S. TIPS

Foreign Government

Cash

U.S. Large, Medium, & Small Cap

Foreign Developed

Foreign Emerging

Real Estate

Commodities

Emerging Markets†

High Yield†

International Corporate†

Foreign Small Cap† Private Equity*

Hedge Funds*

* APCM believes PE & HFs are strategies, not asset classes † Opportunistic asset classes – not in strategic benchmark

Finding The “Optimal” Diversified Portfolio


Expe

cted

Ret

urn

(%)

Expected Risk (%)

Low Risk/Low Return

A portfolio above this curve is impossible

For Illustrative Purposes Only

Portfolios below the curve are inefficient

Medium Risk/Medium Return

High Risk/High Return

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

The Efficient Frontier and Portfolio Optimization

Assumptions and Efficient Frontier


APCM Annualized Return and Risk Assumptions

7 Year Horizon Return Risk

U.S. Large Cap Equities 8.5% 17.8%

U.S. Mid Cap Equities 9.2% 20.5%

U.S. Small Cap Equities 9.4% 23.8%

Int’l Developed Equities 9.0% 19.1%

Emerging Market Equities 11.5% 26.8%

REITs 8.5% 25.1%

U.S. Fixed Income 2.8% 4.3%

U.S. TIPS 2.3% 4.2%

International Bonds 2.6% 3.3%

Commodities 5.5% 18.6%

Cash 2.0% 0.6%

Lrg Cap

Mid Cap Sml Cap

EAFE

EM

REIT

U.S. Bonds

TIPS Int’l Bonds

Commodities

Cash

[CELLREF]

[CELLREF]

[CELLREF]

[CELLREF]

[CELLREF]

0%

2%

4%

6%

8%

10%

12%

14%

0% 10% 20% 30%

Retu

rn

Risk

Efficient Frontier

Shaded color in the table above represents the direction of change from APCM’s 2013 assumptions. Red = Lower, Green = Higher, Gray = Unchanged

Which portfolio would you like?


Asset Class 25% Equity 40% Equity 55% Equity 70% Equity 85% Equity15.0% 25.0% 32.0% 35.0% 45.0%

5.0% 10.0% 15.0% 20.0% 25.0%

5.0% 5.0% 5.0% 10.0% 10.0%

0.0% 0.0% 3.0% 5.0% 5.0%

75.0% 60.0% 45.0% 30.0% 15.0%

Return 4.2% 5.1% 6.1% 6.9% 8.0%

Risk 5.7% 7.8% 10.2% 12.7% 15.6%

Ratio 0.74 0.66 0.59 0.55 0.51

Return 6.6% 7.0% 7.5% 7.7% 7.9%

Risk 5.0% 7.1% 9.6% 12.0% 15.0%

Ratio 1.31 0.98 0.78 0.64 0.53

Best 12 Month Period 22.9% 30.2% 38.7% 47.7% 56.7%

Worst 12 Month Period -11.7% -18.9% -26.6% -34.2% -41.1%

Fixed Income

APCM's Forward Looking

Assumptions

Annualized Historical Returns3/1997 - 12/2013

U.S. Equity

International Equity

REITs

Commodities

15%

5%5%

75%

25%

10%5%

60%

32%

15%5%3%

45%35%

20%10%

5%

30%45%

25%

10%5%

15%

Risk and return data from Windham Portfolio Advisor. U.S. Equity includes a blend of large, mid, and small cap stocks. International Equity includes developed and emerging markets. Fixed Income can include U.S. aggregate bonds, U.S. TIPS, international bonds, and cash.

Probability of Loss 70% vs. 55% Equity Portfolios


0

20

40

60

80

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Turb

ulen

ce

Turbulence Threshold

Financial Crisis of 2008 .com Bubble Bursts

Russian Debt Crisis

Historical returns can be characterized as arising from turbulent periods or quiet periods. The turbulence index identifies turbulent periods and quiet periods from 3/1997 through 12/2013.

This separation allows us to estimate risk parameters for each regime and to stress test the selected portfolios by substituting the risk parameters from the turbulent regimes. The probability measures below are presented for a normal regime, in which the risk parameters are based on the entire sample of returns, and for a turbulent regime, which uses a turbulent sub-sample of returns

Data: Windham Portfolio Advisor.

Probability of 15% Loss

End of 7-Year Horizon Within 7-Year Horizon

Normal Period Turbulent Period Normal Period Turbulent Period

55% Equity 1.3% 3.7% 11.3% 22.9%

70% Equity 2.7% 6.0% 20.9% 33.7%

Historical Simulations


Decline in Portfolio 70% Equity Allocation 55% Equity Allocation

Panic of 2008 Nov 2007 – Feb 2009 -39.8% -30.7%

Dot-com Bubble Burst Sept 2000 – Sept 2002 -16.0% -11.1%

Asian-Russian Crisis July 1998 – Aug 1998 -11.1% -8.5%

Peer Asset Allocations


* Other Includes Absolute Return, Hedge Funds, Infrastructure, and Commodities Alaska Permanent Fund Data as of 12/31/2011 and retrieved from Callan APFC Performance Review dated 2/5/2012. Public and Corporate Fund Data from T Rowe Price as of 9/30/2011.

Portfolio Composition Comparison

Alaska Permanent Fund

Public Fund Peers

Corporate Fund Peers

Bonds/Cash 31.4% 29.1% 43.7%

Real Estate 10.6% 6.9% 3.9%

Equities 44.5% 46.9% 38.2%

Other* 13.5% 17.1% 14.2%

Enduring Truths

Diversify, Diversify, Diversify!

Costs are certain, returns are not.

It’s tough to beat benchmarks

Stay the course

Embrace and KISS


Asset Allocation Smooths the Ride


Source: J.P. Morgan Asset Management. Data as of March 31, 2014. Balanced portfolio assumes 70% equity allocation and annual rebalancing.

Presenter

Presentation Notes

Asset Class Returns May Be Lower Than Historical Averages Low inflation means lower nominal returns, but even real returns should be on the soft side Hard to get stocks past 8% (5% nominal GDP growth +2.5% dividends =7.5%) Bond yields close to record low levels. Rising rates will result in capital losses before higher yields kick in and increase reinvestment income. Benefits of diversification have lessened as equity correlations higher and holding bonds (as insurance) is more expensive. But stay diversified across many asset classes!

Costs are certain, returns are not.


Lipper Active Management Peer Group

1.08%

Vanguard 0.19%

0.0%

0.5%

1.0%

1.5%

Fund Management Fees

Ex

pe

ns

e

Ra

ti

o

2013 Average Expense Ratios

Data: Vanguard and Lipper as of December 31, 2013

It’s Tough to Beat Benchmarks


13% 12% 12%

30%

0%

25%

50%

75%

100%

All Large Cap Funds S&P 500

All Mid Cap Funds S&P 400

All Small Cap Funds S&P 600

International Funds S&P 700

Percentage of Equity Mutual Funds that Outperformed the Index

Over a 5 year period ending June 30, 2014. Equal weighted. Net Returns. Data: Standard & Poor’s

Stay the Course


Resist the allure

of the siren song!

stretching for yield,

than at the point of a

gun.

More money has been lost…

investment policy and asset allocation …asset allocation short term operating funds (preservation...

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