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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
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 2
*APCM
Sample Investment Policy
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
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 3
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
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 4
Sample Investment Policy
List of Attachments
Authorized Personnel
Investment Statutes/Ordinances
Repo Agreements
Authorized Dealers
Credit Analysis of Holdings
Safekeeping Agreements
Methodology for Calculating Returns
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 5
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.
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 6
How can I help you Mrs. Investor?
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 7
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?
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 8
In Ancient Times…
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 9
10 Minutes per Trade. 3 Dealers by Phone.
Now Via Electronic Platforms…
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 10
Trade in 15 Seconds. 8 Dealers Simultaneously Through the Web.
Electronic Trading (13 Dealers!) = Better Pricing/Faster
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 11
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
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 12
Warning: Products
can be volatile,
illiquid, and
highly leveraged.
Derivatives: Use EXTREME CAUTION.
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 13
Yield Curve: June 2007 vs. September 2014
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 14
What are you worried about? Income or price stability?
Bond Market Historical Returns
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 15
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
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 16
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
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 17
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
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 18
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?)
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 19
Asset Allocation: Short Term Operating Funds
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
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 20
Asset Allocation: Short Term Operating Funds
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 21
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!
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 22
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
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 23
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)
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 24
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
50% Bonds 50% Stocks
30% Bonds 70% Stocks
Inflation
Asset Allocation for Long Term Invested Assets
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 25
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.
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 26
Asset Allocation Principals
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 27
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
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 28
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”
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 29
Asset Allocation
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 30
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
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 31
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
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 32
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
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 33
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?
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 34
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
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 35
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
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 36
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
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 37
* 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
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 38
Asset Allocation Smooths the Ride
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 39
Source: J.P. Morgan Asset Management. Data as of March 31, 2014. Balanced portfolio assumes 70% equity allocation and annual rebalancing.
Costs are certain, returns are not.
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 40
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
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 41
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
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 42
Resist the allure
of the siren song!
stretching for yield,
than at the point of a
gun.
More money has been lost…
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