a strategic approach to public funds investing

© PFM 1

A Strategic Approach toPublic Funds Investing

Chris Daniel, CFA, CPA, CTPChief Investment Officer, City of Albuquerque

Luke Schneider, CFADirector, PFM

March 22, 2017

© PFM 2

Overview

• Too often, public funds investment programs have taken a backseat to public finance and other

Treasury programs

• Constituents’ financial assets deserve to be optimized, rather than just protected

• This approach can add value for virtually any sized government’s cash or short-term investment

pool(s)

• We need to recalibrate our perspective of the public funds’ cornerstones of Safety, Liquidity, &

Return

• Predominant value-added is found in asset allocation and portfolio risk management, not security

selection or a focus on esoteric yield-based products

• Modern Portfolio Theory has important applications to a public funds investment program

• Value proposition: Appraisal, attribution, and value-added vs. the cost of implementation and

management

© PFM 3

The General State of Municipal Investing

• The Investment Officer often wears many hats.

• Investment programs are often subordinated to public finance, budgeting, accounting, and other

treasury operations.

• Safety is often defined in terms of credit risk, and is prioritized over Liquidity and Return.

• Statutory constraints on asset classes and investment types often compel entities to seek depository

placements and Treasury/Agency issues.

• The brokerage community often guides us toward a security-level focus on commission-rich,

callable, and exotic bonds like “step-ups” and others, none of which are ideal in a portfolio setting,

rarely outperforming simple bond structures.

• As a result, we are making investing more complicated than it needs to be. The focus should be on a

fundamental portfolio perspective.

• But wait! Isn’t that too complex? How can I overhaul our investment program, and how will I

ever get our investment committee/governing body to buy off?

© PFM 4

Getting Past Myths

1. Myth: Our employer and constituents only want us to keep our cash “safe” (from default). Making a return on

investment is of distant, secondary importance.

Fact: We should forecast our monthly cash flows, keep enough liquid, stable-value cash on hand to cover

the peak net outflow point of the cycle, then prudently invest the (usually much larger) residual.

2. Myth: We can only invest in collateralized deposits and U.S. Treasury and Agency securities, and perhaps our State’s

municipal issues.

Fact: Looking closely at the guiding Statutes may offer expanded options. AG and/or internal counsel

opinion is helpful, but program oversight must make an informed determination.

3. Myth: We don’t have enough money to warrant an asset allocation approach.

Fact: The incremental income received from an asset allocation strategy is material even for smaller

entities’ portfolios.

4. Myth: An asset allocation approach is too complex for my entity to implement and manage. Oh, and I certainly can’t

afford an advisor to assist me with this.

Fact: An asset allocation approach is conceptually intuitive. The potential returns are attractive net of

fees, should you choose to retain an advisor.

© PFM 5

Modern Portfolio Theory

• What’s modern about it?

It was developed in the 1950s by Nobel Laureate Harry Markowitz.

• Asset classes – groups of assets with similar attributes. With respect to fixed income, these are fixed

income sectors that are not highly correlated

• Asset allocation – diversifying asset classes to achieve a higher return per unit of risk exposure,

based on each entity’s its risk tolerance and investment constraints

• Systematic risk – risk that cannot be diversified away through asset allocation. Examples include

interest rate changes, inflation, recessions, and geopolitical events

© PFM 6

Modern Portfolio Theory

• Modern Portfolio Theory assumes investors are risk-averse meaning that given two portfolios

offering the same expected return, investors will prefer the less risky one.

• Doesn’t this align with public funds’ emphasis on Safety?

• Our overall objective is to earn the highest return per unit of risk exposure.

• Portfolios that earn the highest return for a given risk exposure, or lowest risk for a given return

objective, are referred to as efficient portfolios.

Source:peerlendingsurvey.com

© PFM 7

Safety, Liquidity, Return: Pillars of Public Funds Investing

Liquidity Safety Return

• Liquidity is best managed

through a “liquidity/core”

portfolio bifurcation.

• Forecast the peak cash need

over the cycle, and then set

that money aside in a “liquidity

portfolio” (liquidity instrument

selection is beyond the scope

of this presentation).

• In the “core portfolio,” safety

and return should be

managed in a complementary

sense, not as one

subordinated to the other.

• In an investment sense, safety

can be described as the

minimization of risk.

• Traditionally, public funds

investors focus on credit risk,

i.e., default risk.

• The asset allocation

approach focuses on the

portfolio’s total risk

(standard deviation) and by

managing interest rate risk

(duration).

• Return does not only mean

yield. Return is total return

(yield plus capital appreciation

and depreciation).

• Total return captures the

reward or penalty for the risk

assumed, and captures the

current value.

• Mark-to-market is now required

by accounting

pronouncements.

© PFM 8

What is Return?

Interest

Earnings

Unrealized

Gains/Losses

Realized

Gains/Losses

Total

Return

© PFM 9

What is Liquidity?

• Ensuring you have enough liquid investments available for daily obligations

• These assets are cash or investments with very short maturities

© PFM 10

What is Safety?

• Liquidity risk has been mitigated, but core portfolio investments are exposed to different risks

• Safety is ensuring your portfolio is invested in permissible asset classes and that the structure is

aligned with your entity’s risk tolerance.

• Total risk (standard deviation) in fixed income portfolios is made up of:

– Interest rate risk

– Credit risk

– Reinvestment rate risk

© PFM 11

Prudent Asset Allocation = Less Risk

• The key to the magic of asset allocation is low correlation. When considering an asset class

universe within fixed income, Treasuries, Agencies, Municipals, Corporates, High Yield,

International, etc. all have correlations are low enough to reduce risk and provide value.

• If previously investing only in Agencies and Treasuries, exposure to other classes can produce

significantly higher returns with little incremental risk exposure. The portfolio may have less volatility

than any of the individual asset classes, outside of cash.

• Importance of asset allocation – a 1994 research paper states that asset allocation decisions

account for 91.5% of the variation between returns across different portfolios1

• Lesson – focus on asset allocation, not buying the “best bond”!

1Global Asset Allocation: Techniques for Optimizing Portfolio Management, edited by Jess Lederman and Robert A. Klein, John Wi ley & Sons, 1994.

© PFM 12

Steps to Optimizing Your Portfolio

1. Set up your program. Assess your entity’s objectives, constraints, and risk tolerance. Create a list

of appropriate asset classes to potentially include in your Core investment portfolio.

2. Gather and evaluate representative historical data including total return, risk, and correlations for

your list of asset classes. Evaluate the diversification capabilities of the proposed asset classes.

Optimize the mix of asset allocations and plot an efficient frontier of portfolios.

3. Determine your Strategic Asset Allocation Select your desired Strategic Asset Allocation (SAA),

taking into account a target portfolio total risk given your risk tolerance. Specify allowable bands

around the policy weight for each asset class and an allowable duration range, referred to as a

Tactical Asset Allocation (TAA).

4. Implement the proposed strategy and monitor performance. Evaluate the risk-adjusted

performance against the benchmark. Adjust and rebalance the Core investment portfolio as

necessary. Gauge the incremental value of the new strategy compared to the default investment

program.

© PFM 13

Step 1 – Set Up Your Program: Assess Objectives & Constraints

• Return Objective: The target is either to exceed the benchmark return (alpha), or ”achieve market

rates of return through interest rate cycles.”

• Risk Objective/Tolerance: “Government can tolerate no more than an X% downside change

in portfolio value over interest rate cycles.”

• Constraints (factors that will constrain the return objective):

1. Liquidity – The Core’s supplementary role as a possible source of liquidity constrains

maturity/duration.

2. Time horizon – The Core’s time horizon is medium-term, which again, impacts duration

decisions.

3. Regulatory – Permissible asset classes are constrained per State Statutes and your own

entity’s interpretation of subject Statute.

4. Tax considerations – Not a constraint for your government’s portfolio.

5. Unique circumstances – The decisions made from the strategic asset allocation results may

entail exposure to asset classes not traditionally utilized by your government. Other such

constraints may include idiosyncratic oversight board preferences, etc.

© PFM 14

Step 1 – Set Up Your Program: Select Potential Asset Classes

• Five criteria are required for effectively specifying asset classes:

1. Assets within the class must be relatively homogeneous.

2. Asset classes should be mutually exclusive.

3. Asset classes should be diversifying.

4. Asset classes should make up a preponderance of investable wealth.

5. An asset class should have the ability to absorb a significant fraction of the portfolio without

seriously affecting the portfolio’s liquidity.

• Look to State Statutes, consult with your legal advisor, and work with your Investment Committee to

derive permissible asset classes.

• Note that criteria #2 and #3 must be tested using a correlation matrix, which will be explained in Step

2.

© PFM 15

Step 1 – Set Up Your Program: Select Potential Asset Classes

• Asset classes you may choose to consider include depending on your state code:

• Make sure to limit the maturity in all classes to protect against interest rate risk.

• Note: In New Mexico, municipal bonds may be purchased directly. However, corporates and a

broader national array of municipal bonds must be accessed via either ETFs or mutual funds, per

NMSA 6-10-10 subsection G(1).

• Asset classes that meet the five criteria above and are determined appropriate for your entity

will be used to develop your constrained efficient frontier.

• The City considered other diversifying asset classes such as high-yield and foreign bonds, but

assessment of the City’s risk tolerance profile led us to exclude them from the optimization study.

• U.S. Treasuries • BBB-Rated Corporates

• Agency Bullets • TIPS (Treasury Inflation Protected Securities)

• Agency Callables • AAA-A Rated Asset-Backed Securities

• Municipals • FHLMC & FNMA MBS

• AAA-A Rated Corporates • AAA-Rated Commercial MBS

© PFM 16

Step 1 – Set Up Your Program: Measure Your Entity’s Risk Tolerance

• We can keep safety at the forefront by

grounding the investment program on

tolerance for risk.

• Risk tolerance is the aversion to, or appetite

for, assuming risk.

• This can be measured via a risk tolerance

questionnaire, which is then quantified for use

in the optimization process.

• It is critical to determine your entity’s risk

tolerance and let it drive the optimal return

level.

Sample Risk Tolerance Questionnaire

© PFM 17

Step 2 – Gather & Evaluate Representative Historical Data

• The following historical data of various asset classes was collected from the representative 1-5 year

BofA/ML indices1:

• Granted, historical performance is not indicative of future results, but the data spans several

economic cycles and can be viewed as reversion to the mean.

• In any event, the Modern Portfolio Theory holds true in any market cycle.Source: Bloomberg, as of 2/28/16.1Historical data spans 1/31/02 to 2/28/16 except for floating-rate treasuries, which begins at the index’s inception date of 1/31/14

Asset ClassReturn

(Annualized)

Standard Deviation(Annualized)

U.S. Treasuries 2.89% 2.02%

Agency Bullets 3.19% 1.97%

Agency Callables 2.32% 1.17%

Municipals 2.88% 1.61%

Corporates AAA-A 3.91% 2.85%

Corporates BBB 4.96% 2.76%

TIPS 3.77% 3.02%

Asset-Backed (Fixed) AAA-A 3.05% 1.88%

CMBS (Fixed) AAA 4.71% 5.27%

Floating-Rate Treasuries1 0.33% 0.13%

FHLMC MBS 4.49% 3.08%

© PFM 18


• Graph the returns of each asset class against their standard deviations (measure of risk).

Source: Bloomberg

U.S. Treasuries2.89%

Agency Bullets3.19%

Agency Callables2.32%

Municipals2.88%

Corporates AAA-A3.91%

Corporates BBB4.96%

TIPS3.77%

Asset-Backed3.05%

Commercial MBS AAA4.71%

Floating Treasuries0.33%

FHLMC MBS4.49%

0%

1%

2%

3%

4%

5%

6%

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5%

An

nu

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Standard Deviation

© PFM 19


• From the historical data, we are able to construct a correlation matrix between the proposed asset classes.

• The lower the correlation between two asset classes, the more attractive they are from a portfolio perspective.

Source: Bloomberg, as of 2/28/16.

U.S.

Treasuries

Agency

Bullets

Agency

CallablesM unicipals

Corporates

AAA-A

Corporates

BBBTIPS

Asset-

BackedCM BS

Floating

Treasuries

FHLM C

M BS

U.S.

Treasuries1.00

Agency

Bullets0.93 1.00

Agency

Callables0.86 0.89 1.00

M unicipals 0.62 0.69 0.69 1.00

Corporates

AAA-A0.46 0.60 0.53 0.60 1.00

Corporates

BBB0.20 0.36 0.34 0.43 0.81 1.00

TIPS 0.50 0.58 0.51 0.47 0.66 0.68 1.00

Asset-

Backed0.44 0.51 0.50 0.48 0.71 0.77 0.73 1.00

CM BS 0.25 0.39 0.36 0.46 0.61 0.65 0.62 0.65 1.00

Floating

Treasuries-0.13 -0.10 -0.10 -0.02 -0.02 0.19 0.22 -0.06 -0.09 1.00

FHLM C

M BS0.78 0.83 0.81 0.65 0.53 0.42 0.51 0.51 0.33 -0.16 1.00

© PFM 20

Step 2 – Gather & Evaluate Representative Historical Data: Optimal Allocations

• Process the historical data through an MVO (Mean-Variance Optimizer), which one of your more

sophisticated broker/dealers or an advisor can do. This will produce an efficient frontier.

o Note: Alternatively, you can use Microsoft Excel’s “Solver” functionality to run the optimization.

• The efficient frontier offers a range of optimal portfolios for your investment oversight committee to

choose from.

• All portfolio mixes lying on the efficient frontier line offer:

• The highest return for the specified level of risk exposure; or,

• The lowest risk for the specified level of return.

• The efficient frontier can be plotted as a graph. The X and Y axes are Risk (standard deviation)

and Return, respectively.

• Assess the various efficient portfolios for the most appropriate selection based on your risk

tolerance.

© PFM 21


Agency Bullets3.19%


Municipals2.88%


Corporates BBB4.96%

TIPS3.77%

Asset-Backed3.05%



FHLMC MBS4.49%

Optimized Portfolio4.44%

Legacy Portfolio2.47%

0%

1%

2%

3%

4%

5%

6%

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5%

An

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Standard Deviation

Step 2 – Gather & Evaluate Representative Historical Data: The Efficient Frontier

Source: Bloomberg

Notice that none of these asset classes are efficient on their own.

You can achieve a higher return for the same risk exposure, or the same return for less risk exposure, by selecting a portfolio on the Efficient Frontier.

Incorporating a low correlating asset class like high yield bonds would shift the frontier farther out, offering even higher returns for a given risk exposure, or a target return at an even lower risk exposure.

© PFM 22

Step 3 – Determine Your Strategic Asset Allocation (SAA)

• Below are the inputs and outputs from our MVO (mean-variance optimizer) model. The historical data we have

collected (standard deviations, returns, durations) serve as our inputs. In this example, we specified to the MVO

model that we desire a historical standard deviation (risk) of 1.90% with no asset class constraints.

• The asset class weights (grey boxes) are the values being solved for by the MVO model. The final row reflects the

predicted characteristics of the blended, optimized portfolio, informing us of what type of asset allocation will generate

our desired risk and/or return characteristics. In this example, the model has optimized our inputs to generate an

asset class allocation yielding a historical return of 4.44%.

Source: Bloomberg

Example of an Efficient Portfolio

Asset Class WeightStandard

Deviation

Downside

Deviation

Historical

Return

Sharpe

Ratio

Sortino

Ratio

Effective

Duration

U.S. Treasuries 0.0% 2.02% 1.13% 2.89% 1.41 2.53 2.72

Agency Bullets 20.9% 1.97% 1.09% 3.19% 1.60 2.90 2.41

Agency Callables 0.0% 1.17% 0.65% 2.32% 1.95 3.53 1.85

Municipals 0.0% 1.61% 0.92% 2.88% 1.76 3.07 2.41

Corporates AAA-A 0.0% 2.85% 1.90% 3.91% 1.36 2.03 2.75

Corporates BBB 46.5% 2.76% 1.60% 4.96% 1.78 3.08 2.82

TIPS 0.0% 3.02% 1.71% 3.77% 1.23 2.18 2.20

Asset-Backed 0.0% 1.88% 1.07% 3.05% 1.61 2.81 1.67

CMBS AAA 0.0% 5.27% 3.59% 4.71% 0.89 1.30 3.13

Floating Treasuries 0.0% 0.13% 0.03% 0.33% 2.21 9.47 0.16

FHLMC MBS 32.6% 3.08% 1.81% 4.49% 1.45 2.46 4.76

Total Portfolio 100.0% 1.90% 1.10% 4.44% 2.31 3.99 3.37

© PFM 23

Step 3 – Determine Your Strategic Asset Allocation (SAA)

• Observations:

1. The portfolio’s total risk is lower than most of the individual asset class total risks.

2. The portfolio’s total return is greater than that of each individual asset class, except for BBB Corporates and

Mortgage-Backed securities.

3. The Sharpe Ratio is higher for the optimized portfolio than for all stand-alone asset classes.

4. Interest rate sensitivity is highly controlled (3.37% change for every 1% parallel change in market rates).

Source: Bloomberg

Example of an Efficient Portfolio

Asset Class WeightStandard

Deviation

Downside

Deviation

Historical

Return

Sharpe

Ratio

Sortino

Ratio

Effective

Duration

U.S. Treasuries 0.0% 2.02% 1.13% 2.89% 1.41 2.53 2.72

Agency Bullets 20.9% 1.97% 1.09% 3.19% 1.60 2.90 2.41

Agency Callables 0.0% 1.17% 0.65% 2.32% 1.95 3.53 1.85

Municipals 0.0% 1.61% 0.92% 2.88% 1.76 3.07 2.41

Corporates AAA-A 0.0% 2.85% 1.90% 3.91% 1.36 2.03 2.75

Corporates BBB 46.5% 2.76% 1.60% 4.96% 1.78 3.08 2.82

TIPS 0.0% 3.02% 1.71% 3.77% 1.23 2.18 2.20

Asset-Backed 0.0% 1.88% 1.07% 3.05% 1.61 2.81 1.67

CMBS AAA 0.0% 5.27% 3.59% 4.71% 0.89 1.30 3.13

Floating Treasuries 0.0% 0.13% 0.03% 0.33% 2.21 9.47 0.16

FHLMC MBS 32.6% 3.08% 1.81% 4.49% 1.45 2.46 4.76

Total Portfolio 100.0% 1.90% 1.10% 4.44% 2.31 3.99 3.37

© PFM 24


Agency Bullets3.19%


Municipals2.88%


Corporates BBB4.96%

TIPS3.77%

Asset-Backed3.05%



FHLMC MBS4.49%

Optimized Portfolio3.36%

Legacy Portfolio2.75%

0%

1%

2%

3%

4%

5%

6%

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5%

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Standard Deviation

Step 3 – Determine Your SAA: Constraining Your Efficient Frontier

Permitted Asset Classes• U.S. Treasuries• Agency Bullets• Agency Callables• Municipals• Corporates AAA-A

Source: Bloomberg

© PFM 25

0 1 2 3 4 5 6 7 8 9 10

1.20% 1.36% 1.52% 1.68% 1.84% 2.00% 2.16% 2.32% 2.48% 2.64% 2.80%

Step 3 – Determine Your SAA: Assess Portfolios in Terms of Risk Tolerance

• Reference the risk tolerance results.

• Score and weight each question for its relative risk aversion.

• Run various desired portfolio allocations through the model.

• Select at least 3-5 portfolios located on the efficient frontier that satisfy your desired asset class

exposure.

• Subject these efficient portfolios to various risk tolerance functions, such as Utility Risk, Shortfall

Risk, and Roy’s Safety-First Ratio.

• Select the portfolio that, on average, provides the best results to these tests, as expressed in

total risk (σ) terms and your asset class preferences

High risk toleranceHigh standard deviation SAA

Low risk toleranceLow standard deviation SAA

Risk tolerance

Standard deviation

© PFM 26

Step 3 – Determine Your SAA

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1.2% 1.3% 1.4% 1.5% 1.6% 1.7% 1.8% 1.9% 2.0% 2.1% 2.2% 2.3% 2.4% 2.5% 2.6% 2.7% 2.8%

Standard Deviation (Risk)

U.S. Treasuries Agency Bullets Agency Callables Municipals Corporates AAA-A

© PFM 27

Step 3 – Determine Your SAA: Develop Risk Bands for Tactical Asset Allocation

• Overlay a range of permissible mixes for each asset classes.

• This range serves as a risk management device, as allocations outside the range may have

substantially different risk characteristics from the intended Strategic Asset Allocation.

• If an asset class moves outside the permissible range, rebalancing of the portfolio is required.

Asset Class Target Allocation Permissible Range

U.S. Treasuries 10% 0% - 20%

Agency Bullets 40% 30% - 50%

Agency Callables 20% 10%- 30%

Municipals 15% 5% - 25%

Corporates AAA-A 15% 5% - 25%

Corporates BBB 0% 0%

TIPS (Treasury Inflation-Protected Securities) 0% 0%

Asset-Backed Securities AAA-A 0% 0%

Commercial MBS AAA 0% 0%

Floating Treasuries 0% 0%

FHLMC Mortgage-Backed Securities 0% 0%

FNMA Mortgage-Backed Securities 0% 0%

© PFM 28

Step 4 – Implement the Proposed Strategy & Monitor Performance

• Work with the broker/dealer community and/or your Investment Advisor to implement the strategy.

• Based on your short-term outlook for key variables such as spread analysis, yield curve analysis,

and asset class relative value analysis (short-term capital markets expectations), you may wish to

vary the weights of certain asset classes from the SAA.

• This is called Tactical Asset Allocation (TAA).

• So, the SAA serves as the custom benchmark/long-term portfolio return objective, and the TAA

attempts to achieve alpha through short-term capital market expectation views (asset class weight

differences from the SAA).

• Security selection is not part of the manager skill equation.

• Based on your short-term market interest rate forecast, you can chose to manage the duration of the

portfolio either short or long of the SAA’s Duration.

• The intent of this approach is to capture the value of diversification while maintaining a discipline that

identifies duration limits and appropriate credit exposure.

© PFM 29


• Why would you make tactical adjustments?

• Your outlook for spreads may vary over time.

Source: Bloomberg

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Spreads to U.S. Treasury (1-5 Year Benchmarks 12/31/2016)

Corporates (A-AAA Rated) Federal Agency Callable Municipals Federal Agency Bullet

© PFM 30


• Your TAA (Tactical Asset Allocation) should be reviewed on a quarterly basis. Weighting variances

from the SAA (Strategic Asset Allocation) are based on your short-term capital markets expectations.

• Shown below is the City’s TAA during the 4th quarter of 2014. Tan reflects an overweight to the SAA,

and yellow reflects an underweight to the SAA.

Illustrative Tactical Asset Allocation

Asset Class SAA TAA (4Q14)

U.S. Treasuries 10% 20%

Agency Bullets 40% 30%

Agency Callables 20% 25%

Municipals 15% 10%

A-AAA Corporates 15% 15%

© PFM 31


• Evaluate performance along the following dimensions:

– Actual asset class weights vs. TAA weights

– Portfolio vs. benchmark SAA Duration

– Portfolio vs. SAA Total Return (Alpha)

– Portfolio vs. short-term Agency/Treasury Index (default program) Total Return

• Recall our overall objective: did we achieve sufficient return to reward us for the additional risk

assumed?

• Sharpe Ratio:

• This is the one of the most important and widely-used fundamental analysis measures of risk-

adjusted return. It’s computed as:

Sharpe Ratio= Portfolio Return – Risk- Free Return

Standard Deviation

In addition to the observed total returns and book income, if our TAA Sharpe ratio for a reasonably long

measurement period exceeds that of the benchmark and of a model of the default public funds allocation,

then we know that our strategy is successful and rewarding us for the incremental risk exposure.

© PFM 32


Source: 1-5 Year BofA/ML indices from Bloomberg, as of 12/31/16.

The maximum outperformance of a callable bond is the initial yield spread, but non-callables can

generate significantly higher returns.

Annual Returns

Callable vs. Non-Callable Agencies

Callable Bullet Difference

2006 4.67% 4.49% 0.19%

2007 6.00% 7.81% -1.81%

2008 4.84% 8.63% -3.79%

2009 2.14% 2.53% -0.39%

2010 1.24% 3.54% -2.30%

2011 1.67% 2.62% -0.95%

2012 0.85% 1.52% -0.67%

2013 -0.01% 0.03% -0.04%

2014 1.38% 1.29% 0.09%

2015 1.28% 0.90% 0.38%

2016 0.81% 1.19% -0.38%

2.26% 3.14% -0.88%-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Small outperformance

Big underperformance

© PFM 34


Source: Bloomberg, as of 2/28/17.

Standard

Deviation

Historical

ReturnSharpe Ratio

Effective

Duration

Difference +0.06% +0.28% +0.12 +0.13

1-5 Year US Treasuries

20%

1-5 Year Agency Bullets

40%

1-5 Year Agency

Callables40%

Traditional Public Entity Portfolio 1-5 Year US Treasuries

10%

1-5 Year Agency Bullets40%

1-5 Year Agency

Callables20%

1-5 Year Municipals

15%

1-5 Year A-AAA

Corporates15%

Optimized Public Entity Portfolio

© PFM 35


*Value assuming an increase of 28 basis points on various portfolio sizes

.28% (difference) Return on Different Portfolio Sizes

Portfolio Size Annual Earnings*

$10,000,000 $28,000

$50,000,000 $140,000

$300,000,000 $840,000

City of Albuquerque’s Book Interest Income

FY 2013 $2.6 Million




© PFM 36


• City of Albuquerque’s recent performance results (total return):

Performance: Core Investment Strategy vs. Previous Strategy

Period 7/31/14 to 6/30/16 on approximately $500 million

Annualized

RateAmount

City’s Cumulative Total Return-to-Date 1.73% $17.9 Million

0-3 Year Custom Treasury/Agency Index (Prior Benchmark) 0.94% $9.0 Million

Total Value Added $8.9 Million

© PFM 37

Conclusion

• Parsing the aggregate investment portfolio into Liquidity and Core components dramatically

reduces the effort involved in matching investments’ cash flow timing to obligations. Core

money can be invested on a value-added total return basis.

• Diversified index-based exposure to asset classes such as corporate bonds, when combined with

traditionally used asset classes (Treasuries and Agencies), can dramatically improve returns over

long investment horizons while meeting governments’ risk tolerance objectives.

• Once implemented, it is a much less time-consuming approach than the traditional Agency-focused

security selection tactics. Focus is shifted to consideration of asset class allocation

adjustments based on forward-looking capital markets expectations.

• Duration management and asset constraints (bands) help to ensure that excessive risk is not taken.

• Even for moderate-sized cash portfolios, the Core/Liquidity portfolio bifurcation approach helps to

ensure the most optimal use of constituent funds.

© PFM 38

Elements of Engagement Break

• “Safety” in a public funds strategy sense can best be managed by:

A. Holding only stable value instruments

B. Holding only “full faith & credit” direct or backed instruments

C. Determining and managing to the entity’s risk tolerance

D. Keeping the cash in the Treasury vault

• Duration is a measure of a portfolio’s or asset’s:

A. Ability to run without stopping

B. Sensitivity to a parallel shift in the yield curve

C. Ability to withstand various interest rate environments

D. Weighted average maturity

© PFM 39


• Who was the Nobel Prize winner who developed Modern Portfolio Theory in the 1950s?

A. William Sharpe

B. Harry Markowitz

C. Jack Treynor

D. Terry Fator

• The Sharpe Ratio measures:

A. How brilliant the investment manager is

B. How well the manager performed vs. his/her peers

C. Absolute return

D. The risk premium per unit of risk assumed

© PFM 40


• The efficient frontier represents portfolio mixes that offer:

A. The highest return for a given level of risk exposure

B. The highest risk for a desired total return

C. An area that’s the habitat for proficient pioneers

D. Possible returns and risks of good portfolios

• The investor’s strategic asset allocation is its:

A. Short term mix based on capital market expectations

B. A vague theory that has no real world application

C. Long term, equilibrium policy asset class mix

D. A 50%/50% Agency/Treasury mix

© PFM 41


• The inputs to a Mean-Variance Optimizer (MVO) model are:

A. Safety, liquidity, and yield

B. Prayer, guess, and luck

C. Good, bad, and ugly

D. Expected returns, standard deviations, and correlations

• The investor’s Tactical Asset Allocation is its:

A. Allocation to different callable structures

B. Short term, tactical adjustment to the asset class mix

C. Decision to parlay at the sports book or not parlay

D. Movement of funds to cash to protect principal.

© PFM 42


• Investment constraints include:

A. Maturity, duration, call date

B. Statutes, ordinances, administrative instructions

C. Liquidity, time horizon, regulatory, taxes, unique circumstances

D. Not enough cash, clueless investment committee, annoying salespeople

• Characteristics of an asset class include all of these except:

A. Homogeneous

B. Mutually exclusive

C. Opposite of an asset with no class

D. Diversifying

© PFM 44

Disclosures

This material is based on information obtained from sources generally believed to be

reliable and available to the public, however neither the City of Albuquerque nor PFM Asset

Management LLC can guarantee its accuracy, completeness or suitability. This material is

for general information purposes only and is not intended to provide specific advice or a

specific recommendation. All statements as to what will or may happen under certain

circumstances are based on assumptions, some but not all of which are noted in the

presentation. Assumptions may or may not be proven correct as actual events occur, and

results may depend on events outside of your or our control. Changes in assumptions may

have a material effect on results. Past performance does not necessarily reflect and is not

a guaranty of future results. The information contained in this presentation is not an offer to

purchase or sell any securities.

a strategic approach to public funds investing

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