Managing Portfolios Without Getting in Over Your Head

© 2006. Chandler Asset Management, Inc.

Kay Chandler, CFAPresident, Chandler Asset Management

April 26, 2006

2

                  

The Topic—Investment Ideas for Smaller Portfolios

Smaller?

Fewer Resources

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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…

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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

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Regardless of Portfolio Size and Available Resources

Safety—maintain appropriate level of exposure to risk

Liquidity• Sufficient short-term investments• Marketable securities• Targeted maturities• Extra layer

Yield (Return,Growth)• Income• Long-term growth

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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

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Portfolio Management Is Risk Management

The greater an investor’s exposure to properly diversified risk, the higher the expected return over time.

The greater an investor’s exposure to risk, the higher will be the volatility of return from period to period.

The objective of “safety” requires establishing risk constraints.

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Tips for Managing Risk Market Risk

Liquidity risk

Reinvestment risk (Callables)

Credit Risk (Non-governmental Issuers)

Other—political, job, etc.

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Exposure To Interest Rate Fluctuations—Market Risk

Market risk• Securities prices change as interest rates

change—in the opposite direction

• Market risk is best measured as modified duration

• Measure effective duration instead when securities have a call feature

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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 can’t 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

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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

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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

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Greater Exposure To Market Risk Leads To Higher Return Over Time

Source: Index return information provided by Merrill Lynch

12/31/2005LAIF $1,525,924 4.32%

1-3 Year Treasury Benchmark $1,596,461 4.79%1-5 Year Government Benchmark $1,646,268 5.11%

Value on 12/31/2005 of $1 million invested 12/31/1995Annualized Return

Higher Duration Portfolios Offer Greater Returns Over Time

$1.00

$1.10

$1.20

$1.30

$1.40

$1.50

$1.60

$1.70

Dec-95

Jun-96

Dec-96

Jun-97

Dec-97

Jun-98

Dec-98

Jun-99

Dec-99

Jun-00

Dec-00

Jun-01

Dec-01

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05

Gro

wth

in m

illio

ns

LAIF

1-3 Year Treasury Benchmark

1-5 Year Government Benchmark

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Greater Exposure To Market Risk Means Higher Volatility

Quarterly Change in Value

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

Qu

arte

rly

To

tal R

ate

of

Ret

urn

LAIF 1-3 Year Treasury Benchm ark 1-5 Year Governm ent Benchm ark

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. .

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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

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Managing Liquidity Risk Liquidity risk (2 definitions)

1. The risk that the portfolio won’t provide adequate cashflow for the agency

2. The risk that a security can’t 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

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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

Definition 1

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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

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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.

95

100

105

110

115

120

125

130

135

1-3 Non-Call Agency 1-3 Callable Agency

99.5

100.0

100.5

101.0

101.5

102.0

102.5

103.0

103.5

Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05

1-3 Non-Call Agency 1-3 Callable Agency

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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 uncertain—in a way that works against the investor

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Credit Risk—the Opportunity

Assuming additional credit risk should result in higher returns

over time

With a similar pattern of volatility of return

$0.95

$1.05

$1.15

$1.25

$1.35

$1.45

$1.55

$1.65

$1.75

$1.85

Gro

wth

in m

illio

ns

1-5 Yr "A" Rated Corps 1-5 Yr Agencies

M onthly Change in Value

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

Mo

nth

ly T

ota

l Rat

e o

f R

etu

rn

1-5 Yr "A" Rated Corps 1-5 Yr Agencies

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Assuming credit risk requires that additional resources be devoted to the investment program

• Moody’s/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 Risk—the Tradeoff

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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

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Benefits of Using an Adviser Enhanced returns net of fees

Reduced risk

Better information—reporting, program evaluation

Internal staff free to perform other duties

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Are There Any Risks?

Third party custodian is essential—an outside adviser should never have custody of assets

The client must monitor• Compliance with Government Code• Compliance with Policy• Performance relative to appropriate benchmarks

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Enjoy the Benefits, Manage the Risks Cash is king—sufficient 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