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Transcript
Managing Portfolios Without Getting in Over Your Head April 26, 2006 Kay Chandler, CFA President, Chandler Asset Management © 2006. Chandler Asset Management, Inc. The Topic—Investment Ideas for Smaller Portfolios Smaller? Fewer Resources 2 A Comparison City of Los Angeles A Medium-sized City • $5 billion + • $300 million • Treasurer • Finance Director • Treas… CIO 3 PMs • Active strategies • Daily Trading 3 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 4 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 5 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 6 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. 7 Tips for Managing Risk Market Risk Liquidity risk Reinvestment risk (Callables) Credit Risk (Non-governmental Issuers) Other—political, job, etc. 8 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 9 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 10 What Is Duration, Anyway? Portfolio size = $50 million Portfolio duration = 2 Interest rate Δ = +2.25% Portfolio MV Δ = $50 million x .02 x 2.25% x -1 MV Δ = ($22,500) Interest rate Δ = -2.25% Portfolio MV Δ = $50 million x .02 x (2.25%) x -1 MV Δ = +$22,500 Portfolio size = $50 million Portfolio duration = 1 Interest rate Δ = +2.25% Portfolio MV Δ = $50 million x .01 x 2.25% x -1 MV Δ = ($11,250) Interest rate Δ = -2.25% Portfolio MV Δ = $50 million x ..01 x (2.25%) x -1 MV Δ = +$11,250 11 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 12 Greater Exposure To Market Risk Leads To Higher Return Over Time Higher Duration Portfolios Offer Greater Returns Over Time $1.70 LAIF $1.60 1-3 Year Treasury Benchmark 1-5 Year Government Benchmark Growth in millions $1.50 $1.40 $1.30 $1.20 $1.10 $1.00 c De 5 -9 nJu 96 c De 6 -9 nJu 97 c De 7 -9 nJu 98 c De 8 -9 nJu 99 c De 9 -9 nJu 00 c De 0 -0 nJu 01 c De 1 -0 nJu 02 c De 2 -0 nJu 03 c De 3 -0 nJu 04 c De 4 -0 nJu 05 c De 5 -0 Source: Index return information provided by Merrill Lynch Value on 12/31/2005 of $1 million invested 12/31/1995 LAIF 1-3 Year Treasury Benchmark 1-5 Year Government Benchmark 12/31/2005 $1,525,924 $1,596,461 $1,646,268 Annualized Return 4.32% 4.79% 5.11% 13 Greater Exposure To Market Risk Means Higher Volatility Higher Duration Portfolios Have Greater Volatility of Return Quarterly Change in Value 2.50% 2.00% Quarterly Total Rate of Return 1.50% 1.00% 0.50% 0.00% -0.50% -1.00% -1.50% LAIF 1-3 Year Treasury Benchm ark ec -0 5 D -0 5 Ju n ec -0 4 D -0 4 Ju n ec -0 3 D -0 3 Ju n ec -0 2 D -0 2 Ju n ec -0 1 D -0 1 Ju n ec -0 0 D -0 0 Ju n ec -9 9 D -9 9 Ju n ec -9 8 D -9 8 Ju n ec -9 7 D -9 7 Ju n ec -9 6 D -9 6 Ju n D ec -9 5 -2.00% 1-5 Year Governm ent Benchm ark 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. . 14 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 15 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 16 Managing Liquidity Risk Definition 1 Definition 1 Determine short-term investment needs through cash flow forecasting and other techniques Maintain sufficient investments in vehicles such as LAIF, money market funds, individual shortterm securities Invest remainder in strategies with higher expected yields 17 Reinvestment Risk 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 18 Value in Callable Securities 135 In a period of falling rates, bullet securities, with higher duration and positive convexity, provide more growth than callables. 130 125 120 115 110 105 100 M ar -9 9 Ju n99 Se p99 D ec -9 9 M ar -0 0 Ju n00 Se p00 D ec -0 0 M ar -0 1 Ju n01 Se p01 D ec -0 1 M ar -0 2 Ju n02 Se p02 D ec -0 2 M ar -0 3 Ju n03 Se p03 D ec -0 3 95 1-3 Non-Call Agency 103.5 1-3 Callable Agency 103.0 102.5 102.0 101.5 101.0 100.5 100.0 99.5 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 1-3 Non-Call Agency Mar-05 Jun-05 Sep-05 Dec-05 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. 1-3 Callable Agency 19 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 20 Credit Risk—the Opportunity $1.85 Assuming additional credit risk should result in higher returns over time 1-5 Yr "A" Rated Corps 1-5 Yr Agencies $1.75 $1.65 $1.55 Growth in millions $1.45 $1.35 $1.25 $1.15 $1.05 $0.95 96 97 98 99 00 01 02 03 04 05 95 96 97 98 99 00 01 02 03 04 05 cccccccccccnnnnnnnnnnJu Ju Ju Ju Ju Ju Ju Ju Ju Ju De De De De De De De De De De De Monthly Change in Value 2.50% 2.00% 1.00% 0.50% 0.00% -0.50% With a similar pattern of volatility of return -1.00% -1.50% -0 5 ec -0 5 D Ju n -0 4 ec -0 4 D Ju n -0 3 ec -0 3 D Ju n -0 2 ec -0 2 D Ju n ec -0 1 -0 1 1-5 Yr "A" Rated Corps D Ju n -0 0 ec -0 0 D Ju n -9 9 ec -9 9 D Ju n -9 8 ec -9 8 D Ju n -9 7 ec -9 7 D Ju n -9 6 ec -9 6 D Ju n ec -9 5 -2.00% D Monthly Total Rate of Return 1.50% 1-5 Yr Agencies 21 Credit Risk—the Tradeoff 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 22 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 23 Benefits of Using an Adviser Enhanced returns net of fees Reduced risk Better information—reporting, program evaluation Internal staff free to perform other duties 24 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 25 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 26