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Portfolio Strategies

Portfolio Strategies. Government Investment Officers Association March 25, 2009. Rick Phillips President & Chief Investment Officer 702-932-5330 rphillips@mainstreetcap.us. Public Fund Investment Managers www.MainStreetCap.us. Public Fund Investment Managers www.MainStreetCap.us. 2.

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Portfolio Strategies

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  1. Portfolio Strategies Government Investment Officers Association March 25, 2009 Rick Phillips President & Chief Investment Officer 702-932-5330 rphillips@mainstreetcap.us Public Fund Investment Managers www.MainStreetCap.us

  2. Public Fund Investment Managers www.MainStreetCap.us 2

  3. Economics: “A Balance of Trade-Offs” “People Respond to Incentives” “Invisible Hand” “Benevolent Hand” Public Fund Investment Managers www.MainStreetCap.us 3

  4. Consumers Pulling Back U.S. Retail Sales—YOY % Change 9/11 S&P -50% NAZ -85% 2002 Public Fund Investment Managers www.MainStreetCap.us 4

  5. Government Stepping Up U.S. Federal Deficit % of Nominal GDP WWII 2009 Estimated: GDP $14.1T, Deficit $1.45T Public Fund Investment Managers www.MainStreetCap.us 5

  6. Federal Reserve Balance Sheet (Assets-Reserves) $3T+? Quantitative Easing Trillions Public Fund Investment Managers www.MainStreetCap.us 6

  7. Adam Smith-Wealth of Nations (1776) “Every individual endeavors as much as he can to employ his capital so that its produce may be of the greatest value. He generally, neither intends to promote the public interest, nor knows how much he is promoting it; he intends only his own gain, led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” Bill Gross (PIMCO)-Investment Outlook (Feb 2009)“The simplicity of the solution, however, is not easily achieved once deflationary momentum takes hold. Animal spirits, once dampened, are hard to reignite; “fear of fear itself” dominates greed. Under such circumstances, the benevolent hand of government is required and Keynes is reincarnated in an attempt to plug the dike via fiscal spending and imaginative monetary policies that support asset prices.” Public Fund Investment Managers www.MainStreetCap.us 7

  8. The Great Depression Public Fund Investment Managers www.MainStreetCap.us 8

  9. Dow Jones Industrial Average It took 25 years to get back to the same level Public Fund Investment Managers www.MainStreetCap.us 9

  10. U.S. Nominal GDP – YOY % Change A Rare Negative Print in 2009? Public Fund Investment Managers www.MainStreetCap.us 10

  11. Public Fund Investment Managers www.MainStreetCap.us 11

  12. U.S. Savings Rate Bad Public Fund Investment Managers www.MainStreetCap.us 12

  13. The Stealth Banking System-CP Outstanding Billions Public Fund Investment Managers www.MainStreetCap.us 13

  14. Subprime Nation: U.S. Federal Debt % of Nominal GDP (IRS: Interest Expense 9 cents/dollar-2007) 2009 Estimated Public Fund Investment Managers www.MainStreetCap.us 14

  15. Public Fund Investment Managers www.MainStreetCap.us 15

  16. U.S. Treasury Debt Outstanding $10.7 Trillion Log Scale Public Fund Investment Managers www.MainStreetCap.us 16

  17. U.S. vs Walmart Credit Default Swaps (CDS) Walmart U.S.A Public Fund Investment Managers www.MainStreetCap.us 17

  18. “The Great Recession” or “The Depression” ?? U.S. Consumer Confidence 9/11 Prime: 21.5% Oil Crisis Gulf War Lowest Recorded Level Public Fund Investment Managers www.MainStreetCap.us 18

  19. Are We Japan? Japanese Nikkei Index Same Level as 25 Years Ago Public Fund Investment Managers www.MainStreetCap.us 19

  20. Japan Real GDP YOY % Change 9.4% 4.2% 2009 Estimated Public Fund Investment Managers www.MainStreetCap.us 20

  21. Japanese Real Estate Prices Source: DailyWealth.com Public Fund Investment Managers www.MainStreetCap.us 21

  22. The Housing Mess "Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited." Ben Bernanke March 2007 Public Fund Investment Managers www.MainStreetCap.us 22

  23. Who/What Got Us Into This Mess? Interest Rates Pushed Down to 40 Year Lows Public Fund Investment Managers www.MainStreetCap.us 23

  24. The Push for Home Ownership Public Fund Investment Managers www.MainStreetCap.us 24

  25. Subprime Lenders Public Fund Investment Managers www.MainStreetCap.us 25

  26. The GSEs Public Fund Investment Managers www.MainStreetCap.us 26

  27. The Enablers Public Fund Investment Managers www.MainStreetCap.us 27

  28. The Buyers CNBC’s House of Cards: “Arturo Trevilla bought a house with an adjustable rate mortgage.  He planned to refinance his mortgage before the payments went up.  The idea seemed simple, but the paperwork was tricky.  Arturo says “it was hard for me to understand…I just trusted a broker.”But with a salary of $900 a week ($46,800 annually*) he knowingly signed documents claiming he made four times as much….and bought a $584,000 San Clemente, CA townhouse.Trevilla eventually lost his home to foreclosure.” *That’s 12.5 times income!! Public Fund Investment Managers www.MainStreetCap.us 28

  29. Public Fund Investment Managers www.MainStreetCap.us 29

  30. A History of Home Values Yale Professor Robert Shiller created an existing home price index back to 1890, factoring in inflation. For example, if a home sold for $100,000 in 1890, it peaked at $202,000 in 2006 and bottomed at $66,000 in 1920. Real return is approximately 1% annually. ? Housing Is a Expense, Not An Investment Public Fund Investment Managers www.MainStreetCap.us 30

  31. ? Approx 100 million households Public Fund Investment Managers www.MainStreetCap.us 31

  32. S&P 500 Stock Index vs U.S. Existing Home Prices $100 Invested Jan 1, 1968 --- Real Returns Public Fund Investment Managers www.MainStreetCap.us 32

  33. S&P 500 Real P/E Ratio vs Long Term Interest Rates Source: Robert Shiller P/E Ratio using 5 year trailing earnings Public Fund Investment Managers www.MainStreetCap.us 33

  34. S&P 500 Quarterly Operating Earnings 2009 Estimates 62 40 First Ever Qtrly Loss 2008-4 to 2009-4 Estimated Historical Avg Public Fund Investment Managers www.MainStreetCap.us 34

  35. Public Fund Investment Managers www.MainStreetCap.us 35

  36. Public Fund Investment Managers www.MainStreetCap.us 36

  37. Public Fund Investment Managers www.MainStreetCap.us 37

  38. The Cost of Missing a Market Rebound S&P 500 Including Dividends, Source: DFA Funds Public Fund Investment Managers www.MainStreetCap.us 38

  39. Public Fund Investment Managers www.MainStreetCap.us 39

  40. S&P 500 Bear Market Rallies Public Fund Investment Managers www.MainStreetCap.us 40

  41. Can You Beat the House? Market Efficiencies – The Random Walk—Winning the Loser’s Game NFL 2008-09 Regular Season/Playoffs 267 Games 121 Won by Favorites— 45% 146 Won by Underdogs—55% Biggest Favorite Win (+35.5): NY Jets 47 vs St. Louis 3 – Spread was 8.5 Biggest Underdog Win (-37.5): New England 13 vs Miami 38 – Spread was 12.5 Avg Season Spread Difference _____? % of Managers Beating Benchmark* Large Cap 10.6% Mid Cap 5.6% Small Cap 8.8% * Journal of Financial Planning 20 yr Study Public Fund Investment Managers www.MainStreetCap.us 41

  42. Questions: Why should state and local governments take any risk with their investment portfolios? Why not buy only overnight treasury repo or 1 week t-bills ? Reason: Investment portfolios are one of the only places in government where incremental revenues can be prudently generated without collecting taxes or fees; thus benefiting their citizenry. Public Fund Investment Managers www.MainStreetCap.us 42

  43. GFOA Model Investment Policy - Foundation Safety:Safety of principal is the foremost objective of the investment program. Investments shall be undertaken in a manner that seeks to ensure the preservation of capital in the overall portfolio. The objective will be to mitigate credit risk and interest rate risk. Liquidity:The investment portfolio shall remain sufficiently liquid to meet all operating requirements that may be reasonably anticipated. This is accomplished by structuring the portfolio so that securities mature concurrent with cash needs to meet anticipated demands (static liquidity). Furthermore, since all possible cash demands cannot be anticipated, the portfolio should consist largely of securities with active secondary or resale markets (dynamic liquidity). A portion of the portfolio may be placed in money market mutual funds or local government investment pools, which offer sameday liquidity for short-term funds. Yield:The investment portfolio shall be designed with the objective of attaining a market rate of return throughout budgetary and economic cycles, taking into account the investment risk constraints and liquidity needs. Return on investment is of secondary importance compared to the safety and liquidity objectives described above. The core of investments are limited to relatively low risk securities in anticipation of earning a fair return, relative to the risk being assumed. Securities shall generally be held until maturity, with the following exceptions: • A security with declining credit may be sold early to minimize loss of principal. • A security swap would improve the quality, yield, or target duration in the portfolio. • Liquidity needs of the portfolio require that the security be sold. Public Fund Investment Managers www.MainStreetCap.us 43

  44. Three Main Portfolio Management Decisions Legal vs. Suitable • Interest Rate Risk: • 1year time horizon/cash flow need: • Cash • Four 3 month securities, • Two 6 month securities • One 1 year security • One 2 year security and sell it in 1 year • Credit Risk: Treasury, Agency, Corporate, ABS • Prepayment/Optionality Risk: Callables, MBS Public Fund Investment Managers www.MainStreetCap.us 44

  45. Fed Funds Futures – Start of FY2008 Public Fund Investment Managers www.MainStreetCap.us 45

  46. U.S. Treasury Yield Curve – FY2008 Fed Funds 5.25 to 2.00 Public Fund Investment Managers www.MainStreetCap.us 46

  47. A Suitable Level of Interest Rate Risk Does It Pay To Extend Maturities? US Treasury Yield Curve 12/87 to 12/08 Avg U.S. Treasury Yields 12/87 to 12/08 “Sweet Spot” *Spread: Yield pickup from previous maturity A $100,000,000 portfolio with an average maturity of 1 year (2yr t-note) verses 1.5 months (3 month t-bill), would have earned an extra $6,700,000 over a 10 year period. (5.24% minus 4.57% = .67%) Data Source: Bloomberg Public Fund Investment Managers www.MainStreetCap.us 47

  48. Sweet Spot Courtesy: Kevin Webb Main Street Sharpe Ratio = (Return – Risk-free rate) / Duration Public Fund Investment Managers www.MainStreetCap.us 48

  49. A Suitable Level of Interest Rate Risk A Budget Perspective • What is the appropriate average maturity or duration for an Operating Fund? • Between 1 and 2 years • An entity generally has to budget interest income 12 to 18 months in advance of the entity’s fiscal year end for the next fiscal year’s budget. • For example, if the portfolio has a 6 month average maturity, budgeting interest income is challenging due to the fluctuation of interest rates (portfolio turns over 3Xs). • If the portfolio has a 1.5 year average maturity, then the existing book yield gives a good approximation of next fiscal year’s interest income (portfolio turns over 1x). Public Fund Investment Managers www.MainStreetCap.us 49

  50. A Suitable Level of Credit Risk 1-3 Years 1-5 Years MBS/ABS Public Fund Investment Managers www.MainStreetCap.us 50

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