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Davidson Fixed Income ManagementDavidson Fixed Income ManagementDeanne Woodring, CFADeanne Woodring, CFA

Managing DirectorManaging Director(866) 999-2374(866) 999-2374

www.DavidsonFIM.comDwoodring@dadco.com

Benchmarking for Public Fund Benchmarking for Public Fund Investment Guidance and PerformanceInvestment Guidance and Performance

BEST PRACTICESBEST PRACTICES““Safety, Liquidity and Return”Safety, Liquidity and Return”

OMFOA - 2008OMFOA - 2008

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YieldYield

Investment Investment PolicyPolicy Benchmark Benchmark ProcessProcess

Effect:Effect:* Purchase date* Purchase date* Maturity of Portfolio* Maturity of Portfolio

Framework:Framework:* Maturity* Maturity* Asset Allocation* Asset Allocation* Broker Relationships* Broker Relationships* Define Goals* Define Goals

Process:Process:* Control Risk* Control Risk* Manage Return* Manage Return* Accountability* Accountability* Strategy* Strategy

Encompassing Portfolio Management Tools

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Prudent Portfolio Management

“The measure of success in managing public fund dollars lies most appropriately in safety and liquidity, with yield there after.”

Dan Dowell Chief Investment Officer State of California

However, there is a responsibility as public fund steward to manage safety, liquidity and returns through process, discipline and planning.

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Reality 2008 – Public Fund Cash Management Process

Investment Policy

Political and Internal

Environment

Risk Return

Safety

Liquidity

Market Rate of Return

Board

Investment Committee

Staff Turnover

Resources (Experience,

time, software, etc.)

Safety

Liquidity Cash-Flow

Mark to Market

Political

Book Yield & Accrual

Performance (Mark to Market)

Optimizing the Growth of

Funds

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Principles Of Investing

Considerations when:

1. Buying a house

2. Buying a car

3. Investing in retirement

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Principles Of Investing = Growth

Considerations when:1. Buying a house: Timing (Market Conditions)

Location (Where to buy)Objectives (What fits your profile)Time Horizon

2. Buying a car: Type of car Resell Value Objectives

Time Horizon

3. Investing in retirement: Objectives

Best ReturnsGrowth ValueTime Horizon

Each consideration will generate a different outcome or dollar value at the end of period of time.

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Yield versus Return

Yield to maturity: Is an assumption of return based on interest rates at the time the bond is purchased and assumes that all cash flow generated from the bond will be reinvested at YTM rate.

Return: Incorporates what really happens to the investment over a period of time.

Changing Interest rates Impact:1. Value of the bonds2. Reinvestment Rates3. New purchase rates

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Does it matter how you invest?

LETS LOOK AT THIS YEAR 2007:$10,000,000.00 or $100,000,000.00

Pool Funds Average Return for 2007 = 5.10%

$10,000,000.00 = $10,510,000$100,000,000.00 = $105,150,000

0-3 Year Treasury Portfolio - 1.2 year Maturity = 6.635% Book Yield 5%

$10,000,000.00 = $10,663,500$100,000,000.00 = $106,635,000.00

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US Treasury 2 Year Note12/31/97 – 12/31/07

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US Treasury 2 Year Note12/31/07 – 03/04/08

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SAFETYSmoothing Out Interest Earnings

• Assumptions– Current Portfolio Size: $ 50,000,000

• Liquid Portion (50%) $ 25,000,000• Core Portion (50%) $ 25,000,000

– Historical Average Rates for last 10 years (12/31/97 – 12/31/07)

Liquid: 4.0% (Average Pool Funds) Core: 4.43% (US Treasury 0-3 year)

– Benchmark

US Treasury 0-3 year Duration: 1.2 yrs

4.42%3.22%2.00%

4.22%4.22%4.00%

4.02%

$ 1,000,000

$ 3,000,000

$ 2,000,000

6.00%

Stay the Same

Increase 200 bp

Decrease 200 bp $ 2,207,500

$ 2,007,500

$ 2,107,500

$ 1,607,500

$ 2,607,500

$ 2,107,500

5.22%

Rates Liquid Only

12 Months Earnings Due to Given Change in RatesCore SplitCore Split

(Interest Only) (with Price Change)

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Facts of public fund investing

• Interest rates change.

• Your entity’s cash flow requirements change.

• Your investments and earnings are impacted by changing rates.

• Forethought into the investment strategy is important. It can have a substantial impact in your earnings outcome.

• Strategy is important and can be applied to any size portfolio.

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Best Practice Benchmark Considerations Incorporate Objectives

• LIQUIDTY = Cash Flow – Liquidity vs. Core

• SAFETY = Asset Allocation - Diversification

• RETURN = Market Risk Exposure Duration

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A Market Benchmark in Review

• Basket of fixed income securities that reflect your entity’s risk and return profile

• Standard investment management tool

• Provides guidelines for investment decisions and portfolio positioning

• Typically used for funds in excess of liquidity requirements (core funds)

• Effective in managing expectations within your organization

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Strategy Utilizing Benchmarks

STEPS:

1. Evaluate return expectations

2. Determine acceptable risk tolerance

3. Establish appropriate benchmark

4. Establish duration targets

5. Determine guidelines

6. Monitor and report performance

7. Rebalance the portfolio

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1. Evaluate Return ExpectationsBased on Duration

Ending Value and Return - Manage Duration$10,000,000.00 Invested Over the Last 10 Years

Value Raw Return/ Annualized

ML 0-1 Year Treasury Index0.5 duration

$14,748,080

47.58% / 3.97%

ML 0-3 Year Treasury Index 1.2 duration

$15,434,000

54.34% / 4.43%

ML 0-5 Year Treasury Index1.85 duration

$15,880,000

58.80% / 4.73%Source: Merrill Lynch indices

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Evaluate ReturnBased on Duration

Ending Value and Return- Manage Duration$10,000,000.00 Invested Over the Last 5 Years

Value Raw Return/ Annualized

ML 0-1 Year Treasury Index0.5 duration

$11,631,000

16.31% / 3.07%

ML 0-3 Year Treasury Index 1.2 duration

$11,651,000

16.51% / 3.10%

ML 0-5 Year Treasury Index1.85 duration

$11,730,000

17.30% / 3.24%Source: Merrill Lynch indices

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Evaluate Return Based on Asset Allocation

Ending Value and Return-$10,000,000.00 Invested Over the Last 5 Years

Value Raw Return/ Annualized

ML 1-3 Year Treasury Index $11,738,000

17.38% / 3.26%

ML 1-3 Year Bullet Agency Index

$11,786,000

17.86% / 3.34%

ML 1-3 Year Callable Agency Index

$11,618,000

16.18% / 3.04%

ML 1-3 Year AA or Better Corporate

$11,826,300

18.263% / 3.41%Source: Merrill Lynch indices

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Outperforming Asset Classes do not repeat year to year

Year What Happened 2 Year Yield Change (y/y)

– 2007 Spreads widened, rates fell, inflation picked up 4.80% to 3.04% – 2006 Rates rose – curve inverted 4.40% to 4.80%– 2005 Spreads were flat, rates rose, inflation high 3.08% to 4.40%– 2004 Rate rose a little, curve flattened 1.83% to 3.08%– 2003 Yields low, unchanged 1.59% to 1.83%

INDEX 2007 2006 2005 2004 2003

US Treasury 1-3 Year 7.317 3.96 1.67 0.91 1.90

US Agency 1-3 Year Bullet 7.124 4.46 1.72 1.15 2.37

US Agency 1-3 Year Callable 5.768 4.63 1.87 1.26 1.78

TIPS 1-3 Year 8.73 3.08 2.25  

1-3 Year Corp A-AAA 6.041 4.62 1.96 1.45 3.82

0-3 Yrs WAL Mortgages 6.948 4.64 2.15 2.80 1.83

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Evaluate Return Based on Yield Curve

Ending Value and Return-$10,000,000.00 Invested Over the Last 5 Years

Value Raw Return/

Annualized

1 Year Sector – Treasury $11,569,000

15.69%/2.96%

2 Year Sector – Treasury $11,660,900

16.60%/312%

3 Year Sector _ Treasury $11,816,900

18.17%/3.39%

5 Year Sector - Treasury $11,917,200

19.17%/3.58%

Source: Merrill Lynch indices

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2. Determine Acceptable Risk ToleranceMark to Market

100bp+/- 200bp+/-

Index Duration

% P Value % P Value

Merrill 0-1 Year

.58 .58% $58,000 1% $116,000

Merrill 0-3 Year

1.2 2% $120,000 2.4%

$240,000

Merrill 0-5 Year

1.85 1.85% $185,000 3.7%

$370,000

$10,000,000 Portfolio$10,000,000 Portfolio

•Value Change Calculation: $100,000,000 (portfolio size) * 1.2 (duration) * .01 (rate move) = $1,200,000

•2 YEAR TREASURY NOTE JUNE 1997 – JUNE 2007•Average annual yield change (high to low) was 153 basis points•Standard Deviation is 51 basis points•One Standard Deviation range (68%) is 102 bp to 204 bp•Two Standard Deviation range (95%) is 51 bp to 255 bp

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2. Determine Acceptable Risk Credit Diversification

ASSET ALLOCATION TARGETS  

 

State Cod

e& Policy Practice

Treasury 100% 5%

Agency Securities 100% 80%

Corporate 35% 15%

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3. Establish Appropriate Benchmark

TWO CHOICES: 1. Customize a benchmark that reflects your practices:

5% Treasury 1-3 Year Duration 1.6560% Agency 1-3 Year Duration 1.6515% Corporate 1-3 Year Duration 1.76 Average Maturity 1.66

years

2. Pick Standard Market Index:1-3 Agency Index Duration 1.65 0-3 Treasury Index Duration 1.2

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Standard Index Comparison to Practice

COMPARISON OF INDEX TO CUSTOM

INDEX 2007 2006 2005 2004 2003

US Treasury 1-3 Year 7.31 3.96 1.66 .907 1.89

US Agency 1-3Year 7.268 4.54 1.58 1.73 2.30

1-3 Year Corp AA-AAA 6.041 4.62 1.96 1.45 3.82

CUSTOM PRACTICE 5% Treasury 1-3

/80% Agency 1-3 / 15% Corporate Duration 1.55 6.69 4.49 1.77 1.18 2.31

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Standard Index versus Custom Index based on Legal Parameters

COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07

INDEX 2007 2006 2005 2004 200310 Year

US Treasury 0-3 Year 6.635 4.24 2.10 .98 1.66 4.43

US Agency 1-3 Year – Duration 1.65 6.73 4.52 1.77 1.18 2.18 4.97

1-3 Year Corp AA-AAA 6.24 4.56 1.86 1.29 3.18   5.37

Legal Maximum Custom 25% 0-1 / 40% 1-3 Agency /35% 1-3 Corp Duration 1.29 6.24 4.57 2.06 1.21 2.30 4.85

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Standard Index versus Custom Index based on Legal Parameters

COMPARISON OF INDEX TO CUSTOM LEGAL 12/31/07

INDEX 2007 2006 2005 2004 200310 Year

DFIM 0-3 Year Index – 1.29 Duration - OREGON 6.47 4.58 1.98 1.18 2.00 4.76

Legal Maximum Custom 25% 0-1 / 40% 1-3 Agency /35% 1-3 Corp Duration 1.29 6.24 4.57 2.06 1.21 2.30 4.85

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Management

Establish Benchmark Establish Benchmark

Select the Agency/Treasury 0-3 year Index

1. Duration is appropriate 2. Agency exposure appropriate3. Add value when spreads are wide on corporate and agency

issues

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4. Establish Duration Targets

US Treasury

Historical Average Rates Current Rates

5 Year(12/31/02 - 12/31/07)

10 Year(12/31/97 - 12/31/07)

As of: 3/7/08

3 Month 2.90 3.51 1.42

6 Month 3.09 3.65 1.51

2 Year 3.31 3.95 1.48

5 Year 3.82 4.38 2.40

Historical Yield Levels

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Establish Duration Targets

Duration Neutral

Yields RiseDuration (Risk/Reward)Increases

Neutral point – duration is at neutral point when yield is at average

Duration/Yield Relationship

Yields DeclineDuration (Risk/RewardDeclines

2.0%

6.0%

4.20%

1.51..90 1.41.20

Benchmark: DFIM 0-3 Treasury/ Agency 0-3 YearBenchmark duration: 1.2 years (this is your neutral position)10 year Average rate on 2 year note is 3.9%

Strategy: Based on current rates relative to historical rates portfolios should be approaching their neutral positions.

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5. Determine Guidelines

Target size of core balance

Benchmark to control risk and measure return

$75MM- $100MM

DFIM 0-3 year T/Agency

Duration: Approximately 1.2 years

Asset allocation: Within policy

Maturity structure: Within policy

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Guidelines

Duration rage of portfolio relative to +/- 25% or duration benchmark

Minimum .90years

Maximum 1.5years

Asset Allocation Targets Neutral

5% Treasury70% Agency 20% Callable15% Corporate Securities

Strategy and timeline The portfolio will be adjusted periodically to reflect the above guidelines.

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6. Report on Portfolio

Core Component Of Portfolio - 12/31/07

Liquidity Component of Portfolio

Issue Acq Date

Acq Yield

% Holding

Duration

(Years)

Effective

Duration

(Years)

2,000M FFCB 4 1/18/08 5/5/05 3.858 20% .01 .01

1,000M FHLB 5.125 6/13/08 5/31/06 5.25 10% .5 .5

1,000M FFCB 4.125 9/26/08 9/13/05 4.571 10% .75 .75

2,000M FNMA 5.05 1/12/09-1/08 1/27/06 5.09 20% .9 .1

2,000M FHLB 5 5/15/09 6/15/06 5.25 20% 1.2 1.2

1, 000M FHLMC 4.875 2/9/10 2/10/07 5.000 10% 2.4 2.4

1,000M FHLB 5.375 9/8/10-9/08 Callable

6/30/07 5.375 10% 2.8 1.0

10,000,000 4.85 100% 1.08 .74

15MM State Pool or Short Term Money Market Issues – Rate 4.80%

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Monitor Portfolio Compared to Benchmark

Returns Risk Portfolio Benchmark Portfolio

Benchmark1/31/07 .307% .215% 1.35 1.642/28/07 .791% .797% 1.44 1.623/31/07 .356% .384% 1.53 1.684/30/07 .416% .356% 1.43 1.655/31/07 .001% -.074% 1.46 1.726/30/07 .423% .419% 1.51 1.677/31/07 .729% .911% 1.40 1.648/31/07 .637% 1.028% 1.24 1.619/30/07 .848% .708 1.36 1.6410/31/07 .435% .37% 1.26 1.6111/30/07 1.073% 1.718% 1.32 1.6012/31/07 .414% .262% 1.39 1.61

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Monitor Portfolio Compared to Benchmark ($100,000,000 Portfolio)

Returns YTD - 12/07 Since Inception - 12/97

Portfolio Benchmark Portfolio Benchmark

Raw Return

6.618% 7.317% 67.309 59.079%

Annualized 6.618% 7.317% 5.28% 4.75%

VALUE ADDED SINCE 12/31/97

Portfolio $67,309,000

Benchmark $58,079,000

Pools (0-1) $47,580,000

DIFFERENCEPortfolio vs. Benchmark

$9,230,000

DIFFERENCE Portfolio vs. CASH

$19,729,000

Benchmark: US Treasury 1-3

Duration: 1.65

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7. Rebalance the Portfolio

Conditions to Rebalance:• Large change in interest rates

• Large change in asset class valuations

• Time has shorten duration below guideline

• The yield curve has made a large shift

OBJECTIVE OF REBALANCING

To rebalance duration and asset weighting back to guideline levels.

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Rebalance Portfolio – Decision Process

Scenario:Yields have dropped to 2.5% on the two year noteWant to move portfolio out, but remain short to the

benchmark$50,000,000 portfolio with $10,000,000 (20%) in maturing

bond

Neutral Duration 1.2 yearsCurrent duration .75 years Target duration 1.0 years

Question #1: What maturity do you buy?

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Answer – What If Scenario duration

  Duration% of Portfolio

Weighted Portfolio

Existing .75 80% .60  

Target Buy Issue 2.0 20% 0.40  

New Duration       1.0

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Other Scenarios

Want to stay shorter the benchmark

  Duration

% of Portfolio

Weighted Portfolio

Existing .75 80% .6  

Target Buy Issue 1.0 20% .2  

New Duration       .80

If want to stay shorter but can’t resist the yield on the 3year 3mth callable

  Duration

% of Portfolio

Weighted Portfolio

Existing .75 80% .6  

Target Buy Issue 3/3 mth call 20% 0.5  

New Duration       1.1

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What do you buy?

 Guideline

s Actual Spreads Value

Treasury 5% 0% 0  

Agency Bullet 50% 50% Wide ADD

Agency Callable 20% 30% Wide

Corporate 15% 15% Wide  

Recommendation: Buy 2 year bullet agency

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BEST PRACTICE BENCHMARK 2008 and Beyond

Comply Comply

Comply

   

BEST PRACTICE BENCHMARK

SAFETY LIQUIDTY MARKET RETURN

   

Diversification Requirements Book Yield

Quality Maintenance Benchmark Return

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How to implement?

• Evaluate Internal System and Expertise

• Cost/Benefit Analysis of Outsourcing - Advisors

• Evaluate Value of Improved Process

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Benefits of a Benchmark Strategy

• Clear Sense of Direction

• Focus in Overall Portfolio vs. Yield

• Accountability to Decision Making Process

• Balances Risk and Return

• Communication, Communication, Communication

• Confidence and Peace of Mind

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BENCHMARK RESOURCE

www.DavidsonFim.com

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TOP TEN ISSUES

1. CASH FLOW2. DIVERSIFICATION OF LIQUIDITY AND INVESTMENTS3. DIVERSIFICATION OF MATURITY AND DURATION4. DIVERSIFICATION OF ASSET CLASS5. KNOW THE RISKS IN YOUR PORTFOLIO6. KNOW THE CURRENT MARKET ENVIRONMENT7. HAVE A STRATEGY8. ESTABLISH GUIDELINES9. COMMUNICATE10.MONITOR THE PORTFOLIO

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MARKET OBSERVATIONS

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THE LAST EASE

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Today- Treasuries have lead ease

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Where are Fed Funds Rates and Short Rates Headed?

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YIELD CURVE

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HAVE A PLAN

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THANK YOU