Fitting Enhanced Cash

Into Your Investment Management Process

Presented By:Scott Prickett, CTP, Managing Director

Portfolio Manager

Patti Glock, Associate Vice PresidentClient Services Manager

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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

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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

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2 Year Treasury Historical Perspective

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5 Year Historical U.S. Unemployment Rate

6

5 Year HistoricalChange in Non-Farm Payroll

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5 Year S&P Case-Shiller 20 (YoY)

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5 Year Housing Starts

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5 Year Consumer Confidence (YoY)

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GSE (Agency) Securities

FNMA (Fannie Mae) and FHLMC (Freddie Mac)

Recent Developments

Outlook

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The Big Picture

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 liquid funds and core funds. . (ALLOCATION)

Develop an investment strategyinvestment strategy. (ALLOCATION)

Monitor the markets and investment resultsinvestment results. (ALLOCATION)

Stay disciplined but adjust when needed.

Overview of the Operating Fund Investment Management Process

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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.

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Operating Funds Can Be AllocatedInto Different Tiers

•Each tier is distinct and can be benchmarked

0

5

10

15

20

25

30

35

40

45

50

Short-Term Tier (1–3 Years)

Enhanced Cash Tier (60 Days–1 Year)

Liquidity Tier (0–60 Days, WAM)

Jan Feb March April May June July Aug Sept Oct Nov Dec

•Core FundsEnhanced Cash TierShort-Term Tier

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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)

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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)

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Return Expectations: A Look at Historical Returns for Commonly Used Benchmarks

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

December 31, 2009

Source: Bloomberg

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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)

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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)

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Enhanced Cash Characteristics

Position vs. LGIPs/MMFs and Short-Term Portfolios

LGIP/MMF

Enhanced

Cash

Short-Term

Bond

Common Target Portfolio Duration 0-60 Days

6 Months

To

1 Year

1.5 - 2 Years

Eligible

Investments 2a-7 Statute/Policy Statute/Policy

Maximum

Maturity 13 Months 2 Years 5 Years

Commonly Used Benchmark

LGIP 30 Day

Or

3 Mo T-Bill

0-1 Year Index 1-3 Years

Risk

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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

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Performance Benefits for an Enhanced Cash Allocation Strategy Example #1

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

• $25 Million Total Fund Investment Balance• Blended Percentage Based upon 40% LGIP, 60 % Merrill 0-1 Year Agency Index

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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

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Risk/Return Profile of the 3 Tiers

Source: Bloomberg – Merrill Lynch Index

•Extending the term can add performance but also additional risk.

Risk/Return of Treasury Benchmarks

10 Years Ended 12/31/09

Index 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

• 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%.

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Management Tools Enhanced Cash Portfolios

Yield Curve Analysis

Spread Analysis

GAP Analysis

Credit Analysis

Security Selection

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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

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Maturities

Yie

lds

Review of Basic Curve Types

Positive or “Normal”

Flat

Inverted

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Historical Yield Curve

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Spread Analysis

A systematic comparison of alternative securities.

Helps quantify investment decisions.

Spread analysis is not one dimensional.

Within market sectors

Between market sectors

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Money Market Curves &Yield Spreads

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U.S. Treasury vs. Agencies

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Securities Specific Spread AnalysisRelative Value

GAP (Breakeven) Analysis

Two Examples

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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.

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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.)

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GAP Analysis 1st Example

0.35%

0.21%

?

(Head = 178 Days)

(Tail = 261 Days)

Sept 10, 2010 March 7, 2011 Nov 23, 2011

(Full Term = 439)

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GAP Analysis Example #1 (Bloomberg)

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GAP Analysis 1st Example

0.35%

0.21%

0.65%

(Head = 178 Days)

(Tail = 261 Days)

Sept 10, 2010 March 7, 2011 Nov 23, 2011

(Full Term = 439)

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GAP Analysis 2nd Example

0.72%

0.35%

?

(Head = 439 Days)

(Tail = 305 Days)

Sept 10, 2010 Nov 23, 2011 Sept 23, 2012

(Full Term = 744)

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GAP Analysis Example #2(Bloomberg)

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GAP Analysis 2nd Example

0.72%

0.35%

1.25%

(Head = 439 Days)

(Tail = 305 Days)

Sept 10, 2010 Nov 23, 2011 Sept 23, 2012

(Full Term = 744)

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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.

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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.