Fitting Enhanced Cash
Into Your Investment
Management Process
Presented By:
Scott Prickett, CTP, Managing Director
Portfolio Manager
Patti Glock, Associate Vice President
Client Services Manager
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
2
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
3
2 Year Treasury Historical Perspective
4
5 Year Historical
U.S. Unemployment Rate
5
5 Year Historical
Change in Non-Farm Payroll
6
5 Year S&P Case-Shiller 20 (YoY)
7
5 Year Housing Starts
8
5 Year Consumer Confidence (YoY)
9
GSE (Agency) Securities
 FNMA (Fannie Mae) and FHLMC (Freddie Mac)
 Recent Developments
 Outlook
10
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.
11
Considerations for the Long Term
Allocation of Operating Funds
 Liquidity Allocation



LGIPs
MMFs
(S&P 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.
12
Operating Funds Can Be Allocated
Into Different Tiers
•Core Funds
Enhanced Cash Tier
Short-Term Tier
•Each tier is distinct and
can be benchmarked
50
45
40
35
30
Liquidity Tier (0–60 Days, WAM)
25
20
15
10
Enhanced Cash Tier (60 Days–1 Year)
5
0
Short-Term Tier (1–3 Years)
Jan
Feb
March
April
May
June
July
Aug
Sept Oct
Nov
Dec
13
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)
14
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)
15
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
S&P 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
16
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)
17
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)
18
Enhanced Cash Characteristics
Position vs. LGIPs/MMFs and Short-Term Portfolios
Risk
LGIP/MMF
Enhanced
Cash
Short-Term
Bond
1.5 - 2 Years
Common Target
Portfolio Duration
0-60 Days
6 Months
To
1 Year
Eligible
Investments
2a-7
Statute/Policy
Statute/Policy
Maximum
Maturity
13 Months
2 Years
5 Years
LGIP 30 Day
Or
3 Mo T-Bill
0-1 Year Index
1-3 Years
Commonly Used
Benchmark
19
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
20
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
S&P 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
21
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
S&P 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
22
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
Duration
Overall
Return
Quarters
With
Negative
Returns
S&P 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
Index
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%.
23
Management Tools
Enhanced Cash Portfolios
 Yield Curve Analysis
 Spread Analysis
 GAP Analysis
 Credit Analysis
 Security Selection
24
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
25
Review of Basic Curve Types
Yields
Positive or “Normal”
Flat
Inverted
Maturities
26
Historical Yield Curve
27
Spread Analysis
 A systematic comparison of alternative securities.
 Helps quantify investment decisions.
 Spread analysis is not one dimensional.

Within market sectors

Between market sectors
28
Money Market Curves &Yield Spreads
29
U.S. Treasury vs. Agencies
30
Securities Specific Spread Analysis
Relative Value
31
GAP (Breakeven) Analysis
Two Examples
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.
33
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.)
34
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
35
GAP Analysis Example #1
(Bloomberg)
36
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
37
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
38
GAP Analysis Example #2
(Bloomberg)
39
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
40
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.
41
Summary
 Enhanced cash and or short-term allocation strategies are not
designed to replace Money Market Funds.
 Should be used to supplement an investor’s 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.
42