Managing Portfolios Without Getting in Over Your Head © 2006. Chandler Asset Management, Inc. Kay Chandler, CFA President, Chandler Asset Management April 26, 2006
Dec 10, 2015
Managing Portfolios Without Getting in Over Your Head
© 2006. Chandler Asset Management, Inc.
Kay Chandler, CFAPresident, Chandler Asset Management
April 26, 2006
2
The Topic—Investment Ideas for Smaller Portfolios
Smaller?
Fewer Resources
3
A Comparison
City of Los Angeles• $5 billion +
• Treasurer CIO
3 PMs
• Active strategies
• Daily Trading
A Medium-sized City• $300 million
• Finance Director
• Treas…
4
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
5
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
6
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
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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.
8
Tips for Managing Risk Market Risk
Liquidity risk
Reinvestment risk (Callables)
Credit Risk (Non-governmental Issuers)
Other—political, job, etc.
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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
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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
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What Is Duration, Anyway?
Portfolio size = $50 million
Portfolio duration = 2 Interest rate Δ = +2.25% Portfolio MV Δ = $50
million x 2 x 2.25% x -1 MV Δ = ($2,250,000) Interest rate Δ = -2.25% Portfolio MV Δ = $50
million x 2 x (2.25%) x -1 MV Δ = +$2,250,000
Portfolio size = $50 million
Portfolio duration = 1 Interest rate Δ = +2.25% Portfolio MV Δ = $50
million x 1 x 2.25% x -1 MV Δ = ($1,125,000) Interest rate Δ = -2.25% Portfolio MV Δ = $50
million x 1 x (2.25%) x -1 MV Δ = +$1,125,000
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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
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Greater Exposure To Market Risk Leads To Higher Return Over Time
Source: Index return information provided by Merrill Lynch
12/31/2005LAIF $1,525,924 4.32%
1-3 Year Treasury Benchmark $1,596,461 4.79%1-5 Year Government Benchmark $1,646,268 5.11%
Value on 12/31/2005 of $1 million invested 12/31/1995Annualized Return
Higher Duration Portfolios Offer Greater Returns Over Time
$1.00
$1.10
$1.20
$1.30
$1.40
$1.50
$1.60
$1.70
Dec-95
Jun-96
Dec-96
Jun-97
Dec-97
Jun-98
Dec-98
Jun-99
Dec-99
Jun-00
Dec-00
Jun-01
Dec-01
Jun-02
Dec-02
Jun-03
Dec-03
Jun-04
Dec-04
Jun-05
Dec-05
Gro
wth
in m
illio
ns
LAIF
1-3 Year Treasury Benchmark
1-5 Year Government Benchmark
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Greater Exposure To Market Risk Means Higher Volatility
Quarterly Change in Value
-2.00%
-1.50%
-1.00%
-0.50%
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
Qu
arte
rly
To
tal R
ate
of
Ret
urn
LAIF 1-3 Year Treasury Benchm ark 1-5 Year Governm ent Benchm ark
Higher Duration Portfolios Have Greater Volatility of Return
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. .
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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
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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
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Managing Liquidity Risk
Determine short-term investment needs through cash flow forecasting and other techniques
Maintain sufficient investments in vehicles such as LAIF, money market funds, individual short-term securities
Invest remainder in strategies with higher expected yields
Definition 1
Definition 1
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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
Reinvestment Risk
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Value in Callable Securities
In a period of falling rates, bullet securities, with higher
duration and positive convexity, provide more
growth than callables.
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.
95
100
105
110
115
120
125
130
135
1-3 Non-Call Agency 1-3 Callable Agency
99.5
100.0
100.5
101.0
101.5
102.0
102.5
103.0
103.5
Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05
1-3 Non-Call Agency 1-3 Callable Agency
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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
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Credit Risk—the Opportunity
Assuming additional credit risk should result in higher returns
over time
With a similar pattern of volatility of return
$0.95
$1.05
$1.15
$1.25
$1.35
$1.45
$1.55
$1.65
$1.75
$1.85
Gro
wth
in m
illio
ns
1-5 Yr "A" Rated Corps 1-5 Yr Agencies
M onthly Change in Value
-2.00%
-1.50%
-1.00%
-0.50%
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
Mo
nth
ly T
ota
l Rat
e o
f R
etu
rn
1-5 Yr "A" Rated Corps 1-5 Yr Agencies
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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
Credit Risk—the Tradeoff
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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
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Benefits of Using an Adviser Enhanced returns net of fees
Reduced risk
Better information—reporting, program evaluation
Internal staff free to perform other duties
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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
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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