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HomeMy WebLinkAboutBUDGET & FINANCE AGENDA 01-31-1111 Central Contra Costa Sanitary District REGULAR MEETING OF THE CENTRAL CONTRA COSTA SANITARY DISTRICT BUDGET AND FINANCE COMMITTEE Chair Nejedly Member Hockett Monday, January 31, 2011 3:00 p.m. Executive Conference Room 5019 Imhoff Place Martinez, California INFORMATION FOR THE PUBLIC ADDRESSING THE COMMITTEE ON AN ITEM ON THE AGENDA BO4RD OF DIRECTORS BARBAR 4 D. HOC'KETT Presldent J. 4AIESA. AEJEDLY Presldent Pro Tem AITCH.4EL R. A1('GILL AL 4RI0 AL ,1IE. \ESL\ I DAT7DR. TILLIAAIS PHOAE: (925) 228 -9500 F II: (925) 676 -7211 www centralsan.org Anyone wishing to address the Committee on an item listed on the agenda will be heard when the Committee Chair calls for comments from the audience. The Chair may specify the number of minutes each person will be permitted to speak based on the number of persons wishing to speak and the time available. After the public has commented, the item is closed to further public comment and brought to the Committee for discussion. There is no further comment permitted from the audience unless invited by the Committee. ADDRESSING THE COMMITTEE ON AN ITEM NOT ON THE AGENDA In accordance with state law, the Committee is prohibited from discussing items not calendared on the agenda. You may address the Committee on any items not listed on the agenda, and which are within their jurisdiction, under PUBLIC COMMENTS. Matters brought up which are not on the agenda may be referred to staff for action or calendared on a fixture agenda. AGENDA REPORTS Supporting materials on Committee agenda items are available for public review at the Reception Desk, 5019 Imhoff Place, Martinez. Reports or information relating to agenda items distributed within 72 hours of the meeting to a majority of the Committee are also available for public inspection at the Reception Desk. During the meeting, information and supporting materials are available in the Conference Room. AMERICANS WITH DISABILITIES ACT In accordance with the Americans With Disabilities Act and state law, it is the policy of the Central Contra Costa Sanitary District to offer its public meetings in a manner that is readily accessible to everyone, including those with disabilities. If you are disabled and require special accommodations to participate, please contact the Secretary of the District at least 48 hours in advance of the meeting at (925) 229 -7303. Budget and Finance Committee January 31, 2011 Page 2 1. Call Meeting to Order 2. Public Comments *3. GASB 45 Trust Fourth Quarter Report (Andrew Brown, Investment Advisor) 4. Risk Management *a. Review Loss Control Report b. Discuss outstanding claims C. Discuss new claims 1) Claim from Vanliner Insurance Company 5. Review Expenditures (Item 4.a. in Board Binder) 6. Review December 2010 Financial Statements and Investment Reports (Item 4.b. in Board Binder) 7. Review response from Contra Costa Employees' Retirement Association (CCCERA) (Item 6.a.2) in Board Binder) 8. Reports and Announcements 9. Closed Session a. Conference with Legal Counsel - Anticipated Litigation — initiation of litigation pursuant to Government Code Section 54956.9(c) • One potential case — CCCERA De- pooling issue b. Conference with Legal Counsel - Anticipated Litigation — significant exposure to litigation pursuant to Government Code Section 54956.9(b) • One potential case — Gregory Partners RCRA Notice Letter 10. Report out of Closed Session 11. Adjournment * Attachment L E E 7 ca L V CL C x W CD 0 J H LL C a 4-A. to E U E E m A U � U C O a) m :3 CL C7 ¢ o CL J Q1 E z 0) O J E ca U ae J U r O N izz N r N y.. C CL c N E C � CO E N E CD .. 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Results:' Central Contra Costa Sanitary District Fourth Quarter 2010 Presented by Andrew Brown, CFA HIGHMARK® CAPITAL MANAGEMENT DISCUSSION HIGHLIGHTS- Central Contra Costa Sanitary District Asset Allocation: • Current allocation (1/25/11) 54.5% stocks 42% bonds, 3.5% cash • Large cap domestic 31.5 %, international 8.5 %, small cap 7.5 %, mid -cap 5 %, real estate 2% Performance: 2010 • 4t" quarter 5.6 %, 2010 12.3% • Stocks led by Mid -cap, small -cap, emerging markets, and real estate • Bonds — Good year, 4t" quarter — preview of coming attractions? Outlook • HCM earnings estimate $80 /FY10, $92/FY11 • Jobs /unemployment • Inflation • How to pay for everything? Budget issues — EVERYWHERE. • Piigs vs. emerging markets • Geopolitics Where are we? • Moderate Objective • Servicing /Reports AH IGHMARK December 31, 2010 PARS: Central Contra Costa Sanitary District CAPITAL MANAGEMENT CCCSD Asset Allocation Total Assets: $15,318,173 Period Ending 12 -31 -10 4Q10 Return: 5.6% 1 Year Return: 12.27% Inception -to -Date Return: 22.47% Inception Date: 4 -1 -2009 Fixed Income $6,295,303.00 41% JHIGHMARKO CAPITAL MANAGEMENT Cash December 31, 2010 PARS: Central Contra Costa Sanitary District Equity $8,360,867.00 55% 1 H IG HMARK® Selected Period Performance CAPITAL MANAGEMENT PARS /CENTRAL CONTRA COSTA SANT PRHCP Account 6746030600 Period Ending: 12/31/2010 Account Inception: 04/01/2009 Returns are gross -of -fees unless otherwise noted. Returns for periods over one year are amtualized. The information presented has been obtained from sources believed to be accurate and reliable. Past performance is not indicative of future returns. Securities are not FDIC insured, have no bank guarantee, and may lose value. 3 Year Inception to Date to Date Sector Market Value 1 Month 3 Months (12 Months) 12 Months (21 Months) Cash Equivalents 662,004 .00 .02 .14 .14 .31 iMoneyNet, Inc. Taxable (All) .00 .00 .00 .00 .03 Total Fixed Income 6,295,303 -.54 -.68 7.58 7.58 10.54 BC US Aggregate Bd Index (USD) -1.08 -1.29 6.56 6.56 7.10 Total Equities 8,360,867 6.79 11.10 16.48 16.48 35.26 S &P 500 Composite Index 6.68 10.74 15.05 15.05 32.43 Total Managed Portfolio 15,318,173 3.41 5.60 12.27 12.27 22.47 Account Inception: 04/01/2009 Returns are gross -of -fees unless otherwise noted. Returns for periods over one year are amtualized. The information presented has been obtained from sources believed to be accurate and reliable. Past performance is not indicative of future returns. Securities are not FDIC insured, have no bank guarantee, and may lose value. 3 ASSET ALLOCATION As of De cember 31, 2010 Current Asset Allocation Investment Vehicle 12/31/2010 12/31/2010 Equity 54.61% Large Cap Core 4.53% DNVYX Davis New York Venture Fund Y 693,785 4.55% EXEYX Manning and Napier Equity Fund 695,874 Large Cap Value 6.31% HMIEX HighMark Large Cap Value 966,688 6.26% EILVX Eaton Vance Large Cap Value Fund 1 958,282 Large Cap Growth 4.94% HACAX Harbor Capital Appreciation Instl 756,852 4.96% PRGFX T. Rowe Price Growth Stock Fund 759,688 Mid Cap Value 3.04% TIMVX TIAA -CREF Mid -Cap Value Instl 465,019 Mid Cap Growth 2.06% PNMFX HighMark Geneva Mid Cap Growth Fund 315,161 Small Cap Value 4.06% NSVAX Columbia Small Cap Value Fund II 621,682 Small Cap Growth 2.80% PRNHX T. Rowe Price New Horizons Fund 429,147 International Core 2.49% HIOFX HighMark International Opportunity Fund 381,802 International Value 1.60% DODFX Dodge & Cox International Stock Fund 244,696 International Growth 1.62% MQGIX MFS International Growth Fund 248,312 Emerging Markets 1.83% LZEMX Lazard Emerging Markets Instl Fund 279,754 1.51% RSENX RS Emerging Markets Y 231,534 Real Estate 2.04% FARCX Frist American Real Estate Sec Y 312,591 Fixed Income 41.07% Short -Term 8.99% VFSUX Vanguard Short -Term Corp Adm Fund 1,376,428 Intermediate -Term 16.02% HMBDX HighMark Bond Fund 2,452,022 16.06% PTTRX PIMCO Total Return Instl Fund 2,459,213 Cash 4.32% 4.32% HMDXX HighMark Diversified MM Fund 661,974 TOTAL 100.00% $15,310,503 -A HIGHMARK® December 31, 2010 PARS: Central Contra Costa Sanitary District CAPITAL MANAGEMENT 4 FUND PERFORMANCE As of December 31, 2010 PARS /CENTRAL CONTRA COSTA SANT PRHCP For Periods Ending December 31, 2010 Dodge & Cox Intl Stock 1 -Month 3 -Month Year -to- 1 -Year 3 -Year 5 -Year 10 -Year Fund Name Return Return Date Return Return Return Return Davis NY Venture Y 6.87 10.67 12.40 12.40 -3.62 1.69 2.93 Eaton Vance Large -Cap Value 1 7.52 10.17 10.36 10.36 -5.23 2.26 4.32 HighMark Large Cap Value Fid 9.07 10.19 13.29 13.29 -4.15 0.78 1.61 Harbor Capital Appreciation Instl (3) 3.86 11.47 11.61 11.61 -0.15 2.72 0.58 Manning & Napier Equity Fd 6.93 12.15 13.86 13.86 0.40 4.83 4.75 T. Rowe Price Growth Stock 4.37 11.34 16.93 16.93 -1.11 4.01 2.69 S &P 500 Index 6.68 10.74 15.05 15.05 -2.86 2.29 1.41 HighMark Geneva Mid Cap Growth (1) 5.17 15.30 29.69 29.69 3.87 6.09 6.33 Russell Mid Cap Growth Index 6.24 14.01 26.38 26.38 0.97 4.88 3.12 TIAA -Cref Mid -Cap Value Instl (1) 7.50 12.24 21.20 21.20 -0.36 4.80 - Russell Mid Cap Value Index 7.55 12.24 24.75 24.75 1.01 4.08 8.07 Columbia Small Cap Value II Z 8.21 16.42 25.64 25.64 1.43 4.68 - T. Rowe Price New Horizons 7.79 17.94 34.67 34.67 5.85 6.24 6.64 Russell 2000 Index 7.94 16.25 26.85 26.85 2.22 4.47 6.33 Dodge & Cox Intl Stock 7.96 7.96 13.69 13.69 -3.67 5.03 7.33 HighMark Int'I Opportunities Fid 7.42 7.42 11.85 11.85 -7.15 3.83 5.56 Lazard Emerging Mkt Inst 6.73 5.30 22.81 22.81 2.82 13.51 17.91 RS Emerging Markets Y (4) 7.43 6.43 18.57 18.57 0.54 14.68 17.71 MFS International Growth 1 8.23 9.38 15.24 15.24 -1.49 7.00 6.95 MSCI EAFE Index 8.10 6.61 7.75 7.75 -7.02 2.46 3.50 REIT EQUITY FUNDS First American Real Estate Secs Y (2) 4.74 7.89 30.57 30.57 3.58 5.62 12.53 DJ US Select REIT TR USD 4.74 7.45 28.07 28.07 0.01 2.32 10.42 HighMark Bond Fid -0.86 -0.92 7.67 7.67 6.62 6.01 5.64 Pimco Total Return Inst'I -0.54 -0.92 8.83 8.83 9.10 8.05 7.33 Vanguard Short-Term Investment -Grade Adm -0.23 -0.06 5.32 5.32 4.66 5.01 4.72 BarCap US Aggregate Bond -1.08 -1.29 6.56 6.56 5.90 5.80 5.84 Source: SEI Investments, Morningstar Investments (1) Fund was added to the plan in February 2010 (2) Fund was added to the plan in December 2009 (3) Fund was added to the plan in July 2010 (4) Fund was added to the plan in August 2010 Returns less than one year are not annualized. Past performance is no indication of future results. The information presented has been obtained from sources believed to be accurate and reliable. Securities are not FDIC insured, have no bank guarantee and may lose value. JH IGHMARK@ December 31, 2010 PARS: Central Contra Costa Sanitary District CAPITAL MANAGEMENT INVESTMENT HIGHLIGHTS: HIDDEN VALUE IN PLAIN SIGHT by David Goerz, SVP - Chief Investment Officer Hidden Value in Plain Sight Throughout 2010, we have encouraged investors to embrace the value we perceived in global equities. Our preference favored Emerging Market and U.S. equities, particularly small -cap stocks. These tilts have played out well for our clients last year, even as the U.S. dollar firmed relative to European currencies. Valuations have only improved as strong S &P 500 earnings growth outpaced even our expectations and the index return. We believe equities will outperform other asset classes in 2011, including bonds and alternative assets, as well as providing the best hedge against increasing inflation concerns and rising interest rates. Commodities, particularly gold, may not have much room for further appreciation as financial speculative exposures have increased from $10 billion to more than $250 billion over the last decade. A wider range of investors chased new financial products with an expectation far exceeding the 2.5% return observed for commodities since 1900. Bonds are also significantly overvalued, in our opinion. Given the excessive risk aversion of investors toward equities, measured any number of ways, it is not surprising that there remains Hidden Value in Plain Sight, despite an S &P 500 return of over 96% since March 6, 2008 and reaching the highest level since Lehman's bankruptcy. The key to unlocking the Hidden Value in equities is a visible transition from recovery to a broader expansion. Only then are fund flows likely to swing in favor of equities, benefiting from a rotation out of bonds and alternative investments, including commodities and hedge funds. Real- estate and other distressed investments may still have upside, as confidence improves and write -offs are reversed, even as skeptics remain fearful of another shoe -to- drop. U.S. real GDP has matched our 2.6% beginning -of -year forecast, while global growth expectations of 4.9% are near the upper end of our stronger - than- concensus global growth range of 4.5 -5.0 %, in spite of a second quarter stall and double -dip expectations. It seemed logical to us that the recovery would transition to expansion this year, in spite of various regulatory and legislative inhibitors to growth. Many investors remain skeptical of the stock market after back -to -back bear markets during the "naughts" decade, but such divergence from normal averages typically leads to an inflection point in equity sentiment and mean reversion of long -term asset class returns. Corporate earnings growth and balance sheets haven't been this compelling in many decades. If there is any faith left in equity valuations based on earnings, book value, or dividends there is tremendous Hidden Value in Plain Sight for further equity outperformance. We have observed increased interest in dollar cost averaging into equities and higher dividend seeking portfolios, used as transitional strategies into higher equity exposures. Economic Outlook With another upward revision of U.S. economic growth to 2.6% in the third quarter, rolling annual real GDP of 3.3% exceeded old fashioned normal potential real growth of 2.7 -3.0 %. Now 18 months into an economic expansion, GDP has nominally exceeded the previous peak in 2007. The resilience of consumer spending has surprised most economists, with retail sales growing 7,7 %, well above its 20 -year average of 5.0 %. Similarly, 5.4% growth in industrial production has rebounded from the -12.7% trough in June 2009. Exports increased 15.5% over the last year, while the ISM survey index has been above 50% for 16 months, suggesting purchasing managers believe economic conditions are improving. Profits in the national accounts data (i.e., broader economy) increased 45% over the last year through Q3, outpacing S &P 500 operating earnings growth. Furthermore, estimates for real global growth have been revised higher with consensus expectations of 4.9% now within our range set earlier this year of 4.5 -5.0 %. The strength of economic indicators since June 2009 suggests the U.S. recovery has been stronger than expected in many dimensions, except for unemployment and housing. We address both of these critical issues, as well as inflation expectations below. In spite of the various policy mistakes we perceived throughout 2010 that undermined business and consumer confidence, the economy grew fast enough to produce strong earnings and cash flow growth that has improved balance sheets. Refinancing of corporate H IGHMARK` December 31, 2010 PARS: Central Contra Costa Sanitary District CAPITAL MANAGEMENT INVESTMENT HIGHLIGHTS: HIDDEN VALUE IN PLAIN SIGHT (cost.) and household debt has reduced leverage, as well as interest expense. In contrast, the U.S. Treasury has significantly increased its debt burden, such that its interest expense will increase significantly if interest rates rise. The unemployment rate should decline in 2011, in spite of another extension of unemployment benefits. In Expansion by Natural Causes (Q412010), we outlined our theory about why a recovery in employment has failed to match the strength of the broader economy. We believe that extending unemployment benefits, as with many other misguided stimulus programs, probably caused more harm than good. Extending unemployment benefits seemed like a compassionate thing to do, but are benefits of up to 99 weeks, double the previous maximum rate of 49 weeks, undermining employment growth at great cost to taxpayers? Employers are struggling to fill rapidly increasing job vacancies, up 33.5% according to the Department of Labor, while the unemployment rate among college graduates is 5.1%. There appears to be a mismatch between skills and job vacancies. We also think incentives to not search for a job are too high. Initial claims for unemployment insurance have been trending lower (- 12.3 %), which is encouraging since this indicator has led unemployment rate changes historically. In the chart below, we normalized initial claims to the size of the workforce —we anticipate initial claims falling further, leading to a decline in the unemployment rate to 8.7% in 2011. x r 0 0.0 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 — Unemployment Rate (LeM Initial Claims/Worldorm (Right) Unemployment of 9.8% is below the 1982 recession peak of 10.8 %, but still uncomfortably high, even if it does tend to lag the economic cycle. Hiring managers need confidence that demand is sustainable, even as rising employment costs remain an impediment. High unemployment continues within construction, so an improvement in housing starts is critical to job growth. 2,500 2.000 000 500 New Home Starts 3.000 0 196001 196501 197001 197501 198001 198501 199001 199501 200001 200501 201001 " Peak: 2.2M (12/2005) -- Demand= 1.5 M + Second Homes -- - - - - -- - ------------------------------ -- - - - - - - -- - - - - - - - - - - -- - - - - - - - - - - - - US Employment Household Formation + Replacement+ Second Home 1.65 million = 1.2 mion + 300,000 + 150,000 - - - - 12 1.8 0 0 10 1.s o 8- 1.2 6 0.9 It E E v a os 2 _a 0.3 x r 0 0.0 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 — Unemployment Rate (LeM Initial Claims/Worldorm (Right) Unemployment of 9.8% is below the 1982 recession peak of 10.8 %, but still uncomfortably high, even if it does tend to lag the economic cycle. Hiring managers need confidence that demand is sustainable, even as rising employment costs remain an impediment. High unemployment continues within construction, so an improvement in housing starts is critical to job growth. 2,500 2.000 000 500 New Home Starts 3.000 0 196001 196501 197001 197501 198001 198501 199001 199501 200001 200501 201001 " Peak: 2.2M (12/2005) -- Demand= 1.5 M + Second Homes -- - - - - -- - ------------------------------ -- - - - - - - -- - - - - - - - - - - -- - - - - - - - - - - - - - - - ]Demand= Household Formation + Replacement+ Second Home 1.65 million = 1.2 mion + 300,000 + 150,000 - - - - Source. High Mark Capital estimates and Thomson Datastream Household formation is the driver of housing starts, but during March 2009 - March 2010, U.S. Census reported that just 347,000 households were created. This is well below the historical average of 1.2 million households formed per year. The chart above illustrates the cyclical mean - reverting behavior of housing starts, which is empirically consistent with intuitive sustainable demand estimates of 1.5 million housing units. Low household formation bolsters the case that deferred activity could increase even more sharply once housing confidence improves. Note that there was no analogous decline in birth rates 25 years ago, but rather just the opposite, as an increasing birthrate defined the Echo Boomers, also known as Gen -Y or the Millennials (born 1985- 1995). Source: HighMark Capital estimates and Thomson Datastream J HIGHMARK December 31, 2010 PARS: Central Contra Costa Sanitary District CAPITAL MANAGEMENT 7 INVESTMENT HIGHLIGHTS: HIDDEN VALUE IN PLAIN SIGHT(cont.) We believe that the recovery has failed to meet expectations because the fiscal stimulus was only transitory and failed to offer sustainable incentives. Tax rebates, unemployment benefit extensions, useless research grants, unnecessary infrastructure spending, cash - for - clunkers, and home buyer tax credits increased our national debt, but failed to promote a sustainable expansion. Demand was pulled forward by a few months, but the stimulus retreated just as quickly when individual programs eventually expired. We are now left waiting for the economy to work through an expansion derived from the natural process of recovery. Below we summarize our outlook for 2011- 2012. US I n lation Indicators (Yo Y ch ange ) 12% 10% 8% 6% 4% 2% 0% -2% 4% 1980 Economic Forecasts 2006 2.5 2007 2.6 2008 -1.9 2009 0.1 2010e 2.6 2011e 3.0 2012e 3.0 U.S. GDP (YN Real) Earnings Growth 15.3 -1.6 -27.9 -2.0 38.8 13.1 9.5 CPI Inflation (YN) 2.5 4.2 -0.1 2.8 1.8 2.0 2.5 Unemployment 4.4 5.0 7.4 10.0 9.5 8.7 8.0 Fed Funds Target 5.25 4.25 0.25 0.25 0.25 1.25 2.50 Treasury Notes -10y 4.71 4.03 2.25 3.84 3.32 3.75 4.50 S &P 500 Target 1 1418. 1468. 903. 1115. 1258. 1375. 1 1620. Source: HighMark Capital estimates and Thomson Datastream Inflationary Forces Building The third critical economic issue being actively debated, beyond jobless growth and housing, is inflation expectations, which is so important to setting monetary policy. We have disagreed with the current policy to restart quantitative easing, as announced on November 3rd, and keep the Fed Funds target at the credit crisis level of 0 -%%. U.S. economic growth has been exceeding its long -term average, bolstered by economic demand from emerging markets, while early indicators that suggest higher future inflation are already visible. Source: High Mark Capital Management and Thomson Datastream Many academics contend that inflation should not be a concern given the output gap argument attributable to slack in employment and manufacturing utilization. The recent decline in inflation toward 1 % supports this view. Yet, the Consumer Price Index (CPI) inflation has swung dramatically peaking at 5.5% in July 2008, as commodity prices surged during 2002 -2007, then falling precipitously by September 2009 to -2.0 %. When there is excess supply of something, prices should decline until the market finds a clearing price, assuming that market is free and competitive. Under normal circumstances, this theoretical argument is reasonable, but unemployment and housing have decoupled from the economic cycle. So the debate rages on between the "Output Gap -ers" and the "Pragmatic Vigilantes ". For the Pragmatic Vigilantes, inflation expectations should be a function of commodity prices and other input costs, which are rising and evident in higher producer prices. Food costs have increased materially with rising wheat to meat prices and higher transportation costs that will only accelerate inflation. Other constituents of consumer prices that have been deflationary now have the potential of reversing quickly. Rent equivalent shelter (32% of CPI) was declining with housing weakness, but home prices troughed in January 2009, so rising rental rates and declining vacancies reinforce the inflection point in shelter costs already observed. Energy prices, which are about 10% of the CPI H IGHMARK® December 31, 2010 PARS: Central Contra Costa Sanitary District CAPITAL MANAGEMENT 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 CPI �CW Cae -P %fni 3,ed INVESTMENT HIGHLIGHTS: HIDDEN VALUE IN PLAIN SIGHT (cost.) index, are likely to rebound after the weakness observed in natural gas prices seems to have troughed. A weaker dollar and increasing wages in emerging markets, coupled with higher commodity input costs, are pushing up import prices, even as the U.S. seeks to encourage China to appreciate its currency further. US wages also increased 4.0% over the last 12 months - -so much for employment slack capping inflation. Thus, the drivers of inflation are numerous, while the causes of disinflation have faded. A hike in interest rates to 1.0 -1.5% in 2011 would still be highly stimulative, but keep inflation expectations in check. The economy will be resilient if the Fed can communicate the need to unwind overly stimulative monetary policy, including negative real interest rates. Inflationary forces are building and becoming widespread, so it will grow increasingly difficult to tamp down if the Fed doesn't reposition its stance soon. That will include reversing itself on Quantitative Easing (QE) or the purchase of Treasuries to drive bond yields lower. Failure of Quantitative Easing Evident Introducing QE -1 was a bold and creative move during the Financial Crisis of 2008, but as with most successful interventions, it was predicated on shock - and -awe. Credit markets had seized up, but Fed purchases of mortgage securities was so far outside the scope of what had ever been contemplated, that credit markets responded positively. In fact, it was so successful that in November 2009, the Fed announced it would wind down QE -1 by April 2010, as it had already done with other liquidity programs. Credit spreads tightened, as hoped, and record new debt issuance in 2010 was absorbed well in all sectors. The economic stall in the second quarter was not sufficient to derail economic recovery. On August 27th, at a Federal Reserve sponsored Annual Economic Symposium in Jackson Hole, Chairman Bernanke laid out three policy options for increasing output and employment. They included: (1) re- starting quantitative easing for Treasuries only, (2) enhancing the Fed's communication, or (3) reducing the interest rate paid on excess reserves. Since June, bank credit availability has loosened, but is still tight as higher capital requirement rules and their impact in financial reform legislation and Basel III are still uncertain. Financial conditions couldn't be more different than in 2008 when credit spreads were tight and Treasury yields plunged to historic lows. We preferred the Fed eliminate interest paid on reserves to encourage greater lending, but the Fed has opted for re- starting quantitative easing. Their objective was to drive long -term interest rates lower, stimulating growth, but Treasury bond yields must actually fall for there to be any hope that quantitative easing will work. There was no shock - and -awe in QE -2 by simply purchasing Treasuries and offering a well choreographed program too small and spread out over time to have much effect. Unless mortgage rates fall, we do not think that quantitative easing can help accelerate housing starts or increase investment. It is our belief that QE -2 has failed, because it didn't surprise markets -- -worse than that, it apparently caused investors to increase their inflation expectations instead, driving up Treasury yields. When the Fed announced its intent to purchase Treasuries on November 2 ^d , 10 -year Treasury yields were hovering at 2.6 %, but yields climbed to over 3.5% during December. Mortgage rates have risen almost as much. Now the Fed must find a way to unwind an even larger balance sheet of assets it has purchased. In our opinion, QE -2 is more likely to increase future economic volatility. An advantage of the Fed's monetary mandate is that it isn't a rigid rules -based policy. During mid -2007, the Fed began cutting rates, despite rising commodity prices, and increasing inflation risk that eventually drove CPI inflation over 5.5% in August 2008. The economic risk of tightening credit conditions was too great. Other central banks that were unable to deviate from their inflation target disciplines either kept rates steady or, in the case of the European Central Bank, mistakenly hiked interest rates in July 2008. The Fed's creative efforts to restore liquidity to credit markets worked well, including the first attempt at quantitative easing unleashed on July 24, 2009. While flexibility provides room for more adaptive and effective monetary policy, we believe recent efforts to J HIGHMARK® December 31, 2010 PARS: Central Contra Costa Sanitary District CAPITAL MANAGEMENT INVESTMENT HIGHLIGHTS: HIDDEN VALUE IN PLAIN S /GHT(cont.) keep interest rates at emergency levels of 0 - '/<% and implementation QE -2 are misguided, exacerbating gathering inflation concerns. We think QE -2 should be suspended as it clearly has failed to accomplish its goal. Furthermore, with the economy growing in excess of potential growth and inflationary forces increasing, the Fed should begin to raise interest rates slowly, so as to keep inflation expectations contained. Interest rates of up to 2% would remain stimulative, even as we expect inflation indicators to continue gathering steam. Meanwhile, the year -end rotation of regional bank presidents will result in a notably more hawkish Federal Open Market Committee (FOMC) of the Federal Reserve in 2011, including Dallas Fed President Fisher and Philadelphia Fed President Plosser as voting members. The new San Francisco Fed President has yet to be nominated since Janet Yellen was confirmed as FOMC Vice Chairman. Conclusion Security in an increasingly volatile world is elusive. Correlations change by the week, but persistent patterns, illogical as they may be, have trumped fundamental intuition. Provocateurs seem to get more attention these days. Falling Treasury yields coincided inconceivably with higher gold prices over the last two years. Commodities and hedge funds have supplanted equity exposure, even as the U.S. dollar weakened against the Japanese yen, despite Japan's burden of the highest debt/GDP ratio worldwide, supported by less than half the economic growth rate of the U.S. Investment return expectations have shifted dramatically since the credit crisis of 2008, but popular forecasts bear little resemblance to either capital market theory or long -term empirical observations. We expect the returns of the next 10 years will bear little resemblance to the last 10 years. Investors must be paid to take risk, so an equity risk premium must be observed. We expect investors to adjust their risk preferences, recognizing compelling global equity valuations and rich bond yields, resulting in a dramatic rotation of asset allocation exposures. Cash flows have favored absolute return, commodity and JHIGHMARKS CAPITAL MANAGEMENT bond funds, but skepticism of these strategies, which we expect will increase over time, should re- direct flows into equity and target risk strategies, much like we observed in 2003 -2007 and 1982 -1999. The popularity of absolute return strategies surged in recent years, but was likely the result of a poor decade for equities, and new financial products that increased the liquidity and acceptance of commodities. New funds just a few years old realized voracious, but unsustainable inflows. We believe that as equities reassert their rightful place in the asset class pecking order and interest rates begin to rise, increasing holding costs, enthusiasm for commodities will fade. 2011 will be a transition year for Emerging Market equities and bonds due to higher inflation, increasing interest rates and slowing growth. Brazil and Mexico could disappoint investors, in our opinion, while India faces similar challenges, but without the political uncertainty and better growth prospects. U.S. growth that was better than consensus expected benefited from five key growth drivers we introduced in 2010. We expect inventory contributions observed will fade by mid -year, but increased housing activity has upside potential in 2011 after expanding only modestly last year. Deflation concerns caused by rapid innovation and creative destruction in goods and services have undoubtedly provided strong productivity improvements that over the long -run are more beneficial than problematic. Investors remain bullish on emerging market growth prospects, but higher inflation rates are likely to result in near -term interest rate increases that will hamper growth. We remain overweight U.S. equities, particularly small -cap stocks, as we observe Hidden Value In Plain Sight. We are most concerned that the level of global bond yields, particularly U.S. Treasuries, are too low given global inflation pressures, and are likely to lead to disappointing bond returns in 2011. December 31, 2010 PARS: Central Contra Costa Sanitary District INVESTMENT HIGHLIGHTS: HIDDEN VALUE IN PLAIN SIGHT(cont.) Investment Highlights is a publication of HighMark Capital Management, Inc. This publication is for general information only and is not intended to provide specific advice to any individual. Some information provided herein was obtained from third party sources deemed to be reliable. HighMark Capital Management, Inc. and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark Capital Management, Inc. and future market movements may differ significantly from our expectations. HighMark Capital Management, Inc., a registered investment adviser and subsidiary of Union Bank, N.A., serves as the investment adviser for HighMark Funds. HighMark Funds are distributed by HighMark Funds Distributors, Inc., a wholly owned subsidiary of BNY Mellon Distributors Inc. Union Bank, N.A. provides certain services for the HighMark Funds for which it is compensated. Shares in the HighMark Funds and investments in HighMark Capital Management, Inc. strategies are not deposits, obligations of or guaranteed by the adviser, its parent, or any affiliates. Index performance or any index related data is given for illustrative purposes only and is not indicative of the performance of any portfolio. Note that an investment cannot be made directly in an index. Any performance data shown herein represents returns, and is no guarantee of future results. Investment return and principal value will fluctuate, so that investors' shares, when sold, may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted. Investments involve risk, including possible LOSS of PRINCIPAL, offer NO BANK GUARANTEE, and are NOT INSURED by the FDIC or any other agency. Read the prospectus and carefully consider the HighMark Funds' investment objectives, risk factors and charges and expenses before investing. This and other information, including fees and expenses as well as the most recent performance data, can be found in the HighMark Funds' prospectus, which may be obtained by calling 800.433.6884 or by visiting www.highmarkfunds.com. Entire publication © HighMark Capital Management, Inc. 2011. All rights reserved. H IGHMARK December 31, 2010 PARS: Central Contra Costa Sanitary District CAPITAL MANAGEMENT R HIGHMARK 0 CAPITAL MANAGEMENT HighMark Capital Management, Inc. San Francisco 35 California Street, Suite 1600 Palo Alto San Francisco, CA 94104 Beverly Hills Los Angeles (800) 6 47 - 9 8 57 Irvine Visit us at highmarkcapital.com San Diego Seattle Tacoma Portland Chicago New York ©2oo9 HighMark Capital Management, Inc. 84772 - 1 (11/09)