MEMORANDUM To: Investment Committee Ohio Public Employees Retirement System From: Kristine L. Ford, CFA Brady O’Connell, CFA Mary Bates, Fixed Income Research Date: May 4, 2006 Re: Portfolio Guidelines – Internal TIPS and Internal Short Duration Staff has proposed revisions to the guidelines of the Internal TIPS portfolio and the Internal Short Duration Bond portfolio to allow broader management discretion. These portfolios play specific roles in the Health Care investment program and the guideline revisions are consistent with those roles. Additionally, both sets of guidelines now include a statement that derivatives use must be consistent with the OPERS Derivatives Policy. This is an important addition and serves to further provide risk management controls and oversight for these portfolios. We have reviewed the requested modifications and are comfortable with the changes. Internal TIPS Portfolio The requested changes for the TIPS portfolio shift the management approach from index-matching to providing a modest return benefit through the expanded use of securities outside the benchmark, the Lehman TIPS Index. The guideline revision reduces the minimum amount to be held in Treasury Inflation Protected Securities (TIPS) from 95% to 80%. Quality and issuer diversity constraints were added, and the constraint on duration of the total portfolio relative to the benchmark continues. The role of the portfolio as an inflation hedge is expected to be preserved. The expected performance benefit of 15 basis points over the benchmark was added and appears to be reasonable. The total portfolio tracking error maximum was also increased from 30 basis points to 50 basis points which should serve to control volatility and risk. We are comfortable with the requested revisions and support their approval.

Ennis Knupp + Associates vox 312 715 1700 10 South Riverside Plaza, Suite 1600 fax 312 715 1952 Chicago, Illinois 60606-3709 www.ennisknupp.com

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Ennis Knupp + Associates 2

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Internal Short Duration Bond Portfolio The requested revision expands the ability of the portfolio manager to use securities outside the benchmark which is the Lehman 1-3 Year Government Bond Index. The guidelines have been revised to include a prohibition against highly interest rate sensitive securities. The guidelines also include total portfolio constraints on duration, quality and security diversification. The expected return benefit was raised from 10 basis points to 25 basis points reflecting the expansion in the guidelines, and appears reasonable. Additionally, the tracking error was increased from 30 basis points to 50 basis points consistent with the new guidelines and return expectation, acting as a control for volatility and risk. We are comfortable that these revisions are consistent with a risk-conscious short duration role, and support their approval.

OHIO PUBLIC EMPLOYEES RETIREMENT SYSTEM

277 EAST TOWN STREET, COLUMBUS, OH 43215-4642 1-800-222-PERS (7377)

www.opers.org MEMORANDUM DATE: May 16, 2006 TO: OPERS Retirement Board Members Blake Sherry – Interim Executive Director FROM: Eric France, Portfolio Manager RE: Proposed Changes in the Short Duration Bond Fund Guidelines Proposed Action: Staff recommends to the full Board, the approval of the Proposed Short Duration Bond Fund Portfolio Guidelines as presented in Exhibit 3. Purpose This memorandum presents the rationale for changing the Short Duration Bond Portfolio Guidelines and the proposed approval of the revised guidelines. Background In February, 2005, the staff began to purchase securities for the Short Duration Bond Fund according to the current portfolio guidelines listed as Exhibit 1. This fund is designed to fund part of our healthcare liabilities. This fund is invested primarily in AAA and government securities with a one-to-five-year average life. This relatively short, high quality portfolio provides excellent liquidity for our healthcare needs. The current portfolio guidelines, however, are more conservative than is necessary to meet the liquidity needs of Healthcare Fund. The proposed changes in the guidelines, shown in Exhibit 2, will enable the Short Duration Bond Fund to generate higher returns without materially increasing risk. These proposed changes are firmly based on the experience the staff has attained in managing the portfolio during the past year. Attached are the current guidelines for the Short Duration Bond Fund, and the proposed changes. Considerations There are seven proposed changes in the guidelines.

• First, the limitation on the three-year tracking error will be raised to 50 basis points from the current limitation of 30 basis points.

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• Second, the required government weighting is reduced from 50% to 30%.

• Third, 70% of the portfolio must be invested in government or AAA securities. • Fourth, the average credit quality of the portfolio will be AAA.

• Fifth, mortgage-backed securities that exhibit unusually high interest rate

sensitivity relative to typical U.S. Government agency mortgage pass-through issues shall not be utilized.

• Sixth, derivatives use must be consistent with the OPERS Derivatives Policy.

• Seventh, the annual performance goal versus the benchmark will be raised

from 10 to 25 basis points. Rationale for Action These proposed guidelines would enable OPERS to replace 20% of the government securities in the portfolio with AAA asset-backed, commercial mortgage-backed, and single-family mortgage-backed securities (ABS, CMBS, & MBS). Even with today’s historically tight spreads on non-treasury securities, it is not difficult to find AAA securities that have an expected return that is fifty basis points higher than governments (including security lending income). This change would allow the staff to increase the expected realized yield on the portfolio by approximately 10 basis points (20% X .5%) per year. This would provide approximately $1,221,000 (20% X $1,221,000,000 X .5%) in additional annual returns on the current portfolio. This number would go up as the portfolio grows. It would be $2 million annually on $2 billion dollars. This replacement of government securities with AAA ABS, CMBS, and MBS would have no material effect on the credit quality of the portfolio. The loss rate on agency mortgages has been zero. The cumulative loss rate on all AAA non-agency structured product (ABS, CMBS, and MBS) has been one basis point. The loss rate on short structured product has been even lower. Although this new policy would require fewer government securities, it is more conservative than the current policy because it will place a 30% limit on securities that are rated below AAA.The current policy has a 50% limit on these securities. Also, the proposed policy requires an average credit rating of AAA. The current policy would allow an average rating of AA. Because the proposed changes would allow an increased variance in the portfolio’s composition versus the Lehman 1-3 Year Government Index (the benchmark for the Short Duration Bond Fund), the three-year tracking error limit needs to be raised from 30 basis points to 50 basis points, which is the limit for the Internal Core Fixed Income Portfolio. The proposed tracking error limitation would allow the staff to modestly increase its prepayment risk through the purchase of government agency and AAA non-agency mortgages. The prepayment risk is controlled by the tracking error limit, the five-year average life limit, and the prohibition of highly volatile mortgage securities. If the new guidelines were adopted, the annual excess performance goal should be increased from 10 basis points to 25 basis points. This

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number is based on the performance of the portfolio during the past year and the recent experience of the Internal Core Fixed Income Portfolio, which currently has a tracking error limitation 50 basis points. Recommendation The Global Bonds staff recommends that the Board approve the proposed changes in the Short Duration Bond Fund Guidelines. These changes will allow the staff to increase returns with a negligible increase in risk. This is a prudent strategy given the challenges of funding healthcare benefits in an era of rapidly rising costs.

Exhibit 1

Internal Short-Duration Bond Fund – Portfolio Guidelines Strategy

The internally-managed Short-Duration Bond Fund is designed to meet or exceed the return of the Lehman 1-3 Year Government Bond Index with a low level of tracking error. The primary source of out-performance for the portfolio is security selection. Benchmark The benchmark for the portfolio is the Lehman 1-3 Year Government Bond Index. Risk Control

Tracking Error The maximum tracking error relative to the Lehman 1-3 Year Government Bond

Index is 30 bps on a three-year rolling basis. Prohibitions or Limitations At least 50% of the portfolio will be invested in treasury or agency securities.

Up to 50% of the portfolio may be invested in corporate, ABS, CMBS, and

mortgage backed securities. All holdings must be investment grade; ratings will be based on the lower of

Moody’s, S&P, and Fitch. No more than 15% of the portfolio may be invested in BBB-rated securities.

The maximum exposure to any issuer rated lower than AAA is 2% of the portfolio

on a market value basis.

Short-term (cash and cash-like) investments will primarily be held in a short-term investment fund managed by internal staff. Individual holdings of securities meeting 2a-7 guidelines are also permitted.

All holdings must have an expected average life of five years or less.

All securities must pay both principal and interest in U.S. dollars.

Requirements Maintain effective duration within .20 years of the designated benchmark.

Performance Expectation The objective of the portfolio is to outperform the designated benchmark by 10 basis points per annum on a three-year rolling basis.

Exhibit 2

Internal Short-Duration Bond Fund – Portfolio Guidelines Strategy

The internally-managed Short-Duration Bond Fund is designed to meet or exceed the return of the Lehman 1-3 Year Government Bond Index with a lowmodest level of tracking error. The primary source of out-performance for the portfolio is security selection. Benchmark The benchmark for the portfolio is the Lehman 1-3 Year Government Bond Index. Risk Control

Tracking Error The maximum tracking error relative to the Lehman 1-3 Year Government Bond

Index is 3050 bps on a three-year rolling basis. Prohibitions or Limitations At least 50%30% of the portfolio will be invested in treasury or agency securities.

Up to 50%At least 70% of the portfolio maywill be invested in corporate, ABS,

CMBS, and mortgage backed securities. AAA securities including treasury, agency, ABS, CMBS, MBS and corporates.

The average credit quality of the portfolio will be AAA.

Mortgage-backed securities that exhibit unusually high interest rate sensitivity

relative to typical U.S. Government agency mortgage pass-through issues shall not be utilized. Examples of securities likely to qualify as “highly interest rate sensitive” include IOs, POs, and inverse floaters.

All holdings must be investment grade; ratings will be based on the lower of

Moody’s, S&P, and Fitch. No more than 15% of the portfolio may be invested in BBB-rated securities.

The maximum exposure to any issuer rated lower than AAA is 2% of the portfolio

on a market value basis. Short-term (cash and cash-like) investments will primarily be held in a short-term

investment fund managed by internal staff. Individual holdings of securities meeting 2a-7 guidelines are also permitted.

All holdings must have an expected average life of five years or less.

Exhibit 2

All securities must pay both principal and interest in U.S. dollars.

Derivatives use must be consistent with the OPERS Derivatives Policy.

Requirements Maintain effective duration within .20 years of the designated benchmark.

Performance Expectation The objective of the portfolio is to outperform the designated benchmark by 1025 basis points per annum on a three-year rolling basis.

Exhibit 3

Internal Short-Duration Bond Fund – Portfolio Guidelines Strategy

The internally-managed Short-Duration Bond Fund is designed to meet or exceed the return of the Lehman 1-3 Year Government Bond Index with a modest level of tracking error. The primary source of out-performance for the portfolio is security selection. Benchmark The benchmark for the portfolio is the Lehman 1-3 Year Government Bond Index. Risk Control

Tracking Error The maximum tracking error relative to the Lehman 1-3 Year Government Bond

Index is 50 bps on a three-year rolling basis. Prohibitions or Limitations At least 30% of the portfolio will be invested in treasury or agency securities.

At least 70% of the portfolio will be invested in AAA securities including

treasury, agency, ABS, CMBS, MBS and corporates. The average credit quality of the portfolio will be AAA.

Mortgage-backed securities that exhibit unusually high interest rate sensitivity

relative to typical U.S. Government agency mortgage pass-through issues shall not be utilized. Examples of securities likely to qualify as “highly interest rate sensitive” include IOs, POs, and inverse floaters.

All holdings must be investment grade; ratings will be based on the lower of

Moody’s, S&P, and Fitch. No more than 15% of the portfolio may be invested in BBB-rated securities.

The maximum exposure to any issuer rated lower than AAA is 2% of the portfolio

on a market value basis. Short-term (cash and cash-like) investments will primarily be held in a short-term

investment fund managed by internal staff. Individual holdings of securities meeting 2a-7 guidelines are also permitted.

All holdings must have an expected average life of five years or less.

All securities must pay both principal and interest in U.S. dollars.

Exhibit 3

Derivatives use must be consistent with the OPERS Derivatives Policy.

Requirements Maintain effective duration within .20 years of the designated benchmark.

Performance Expectation The objective of the portfolio is to outperform the designated benchmark by 25 basis points per annum on a three-year rolling basis.

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Proposed Revisions to the Internal Short-Duration Bond

Fund Portfolio Guidelines

5-16-06

At least 30% of the portfolio will be invested in treasury or agency securities.

At least 50% of the portfolio will be invested in treasury or agency securities.

Mortgage-backed securities that exhibit unusually high interest rate sensitivity relative to typical U.S. Government agency mortgage pass-through issues shall not be utilized. Examples of securities likely to qualify as “highly interest rate sensitive” include IOs, POs, and inverse floaters.

The average credit quality of the portfolio will be AAA.

At least 70% of the portfolio will be invested in AAA securities including treasury, agency, ABS,CMBS, MBS and corporates.

Up to 50% of the portfolio may be invested in corporate, ABS,CMBS, and mortgage-backed securities.

Maximum Tracking Error – relative to the Lehman 1-3 Year Govt. Index is 50 bps on a 3-year rolling basis.

Maximum Tracking Error – relative to the Lehman 1-3 Year Govt. Index is 30 bps on a 3-year rolling basis.

Proposed GuidelinesOld Guidelines

Proposed GuidelinesOld Guidelines

The objective of the portfolio is to outperform the designated benchmark by 25 basis points per annum on a three-year rolling basis.

The objective of the portfolio is to outperform the designated benchmark by 10 basis points per annum on a three-year rolling basis.

Derivatives use must be consistent with the OPERS Derivative Policy.

OHIO PUBLIC EMPLOYEES RETIREMENT SYSTEM

277 EAST TOWN STREET, COLUMBUS, OH 43215-4642 1-800-222-PERS (7377)

www.opers.org MEMORANDUM DATE: May 16, 2006 TO: OPERS Retirement Board Members Blake Sherry – Interim Executive Director CC: Jennifer Hom – Director of Investments FROM: John Blue, Portfolio Manager RE: Proposed Changes in the TIPS Portfolio Guidelines Proposed Action: Staff recommends to the full Board, the approval of the Proposed TIPS Guidelines as presented in Exhibit 2. Purpose This memorandum presents the rationale for revising the Internal TIPS (Treasury Inflation Protected Securities) portfolio guidelines. Background In February 2005, staff initiated the management of the new internal TIPS portfolio according to the guidelines in Exhibit 1. This portfolio is used only for the Health Care fund and will grow to 20% of the Health Care Fund at the end of the transition period in December 2006. The current guidelines were designed to be fairly restrictive due to the start-up nature of the portfolio. The guidelines require a minimum of 95% of the portfolio to be invested in TIPS; with the only non-index holdings permitted being cash and fixed rate treasuries. Despite the transaction costs involved in building the portfolio, the portfolio has outperformed its index by 14 bps since inception with 18 bps in tracking error. The portfolio is currently $1.6 billion in total size, and it is now an appropriate time to change the focus from building a new portfolio to adding incremental returns over the index. By introducing a greater use of non-index securities (20% maximum) the portfolio will be able to generate an incremental level of outperformance with a modest level of tracking error, while still maintaining its purpose as an inflation hedge.

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Considerations I recommend the following revisions to the guidelines:

• Increase the maximum three-year tracking error from 30 basis points to 50

basis points. • Increase the performance objective from meeting the return of the benchmark

to exceeding the benchmark by 15 bps per annum on a three–year rolling basis.

• Increase the maximum allocation to non-index securities (TIPS) in the portfolio

from 5% (only fixed rate treasuries and cash) to 20% fixed and floating rate securities other than TIPS.

• Add constraint that all securities must be rated A- or higher. This requirement

was not necessary before since the portfolio consisted only of treasuries.

• Add constraint that the maximum issuer exposure for securities rated lower than AAA will be 2%. Again, this requirement was not previously necessary; since, treasuries are rated AAA.

Rationale for Action The proposed guidelines willl enable staff to replace up to 20% of the TIPS portfolio with non-index securities including fixed rate treasury securities, fixed and floating rate agency, Asset Backed Securities (ABS), Commercial Mortgage Backed Securities (CMBS), and high quality corporate securities. The new guidelines will allow the use of three new strategies:

• Replace short TIPS with short maturity floating rate ABS, CMBS, and high quality corporate securities. These floaters often have higher yields than short TIPS and offer similar return profiles in times of rising inflation.

• Replace longer TIPS with fixed rate treasuries – this is a tactical strategy that

could be utilized at times when our analysis shows that TIPS are overvalued relative to nominal treasuries in the market.

• Change TIPS yield curve exposure – At times when longer dated TIPS are

more attractive than short or intermediate dated TIPS, we can add those securities on a duration-weighted basis and invest the proceeds in cash. With the current tight guidelines, we are constrained in using such strategies because of the 95% minimum on TIPS holdings.

The increase in the tracking error from 30 to 50 bps reflects the additional risk from increasing the use of out of index securities, and is appropriate given the proposed

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objective of outperforming the Lehman TIPS Index by 15 bps per annum on a three-year rolling basis. Recommendation The Global Bonds staff recommends that the Board approve the proposed changes for the Internal TIPS portfolio guidelines. These changes will allow the staff to increase potential returns with an incremental increase in risk.

Exhibit 1

UPDATED 2/8/05

Internal TIPS - Portfolio Guidelines Strategy

The Internal TIPS portfolio is designed to meet the return of the Lehman TIPS Index with a low level of tracking error. Benchmark The benchmark for the portfolio is the Lehman TIPS Index. Risk Control

Tracking Error The maximum tracking error relative to the Lehman TIPS Index is 30 bps on a

three-year rolling basis. Prohibitions or Limitations At least 95% of the portfolio will be invested in Treasury Inflation Protected

Securities (TIPS) issued by the U.S. Treasury. Up to 5% of the portfolio may be invested in fixed-rate treasuries.

Short-term investments will primarily be held in a short-term investment fund

managed by internal staff. Individual holdings of securities meeting 2a-7 guidelines are also permitted.

All securities must pay both principal and interest in U.S. dollars.

Requirements Maintain effective duration within 0.30 years of the designated benchmark.

Performance Expectation The objective of the portfolio is to meet the performance of the designated benchmark on a three-year rolling basis.

Exhibit 2

UPDATED 2/8/05

Internal TIPS - Portfolio Guidelines Revised 5-06

Strategy

The Internal TIPS portfolio is designed to meet or exceed the return of the Lehman TIPS Index with a low level of tracking error. The primary source of outperformance is security selection. Benchmark The benchmark for the portfolio is the Lehman TIPS Index. Risk Control

Tracking Error The maximum tracking error relative to the Lehman TIPS Index is 3050 bps on a three-

year rolling basis. Prohibitions or Limitations At least 95%80% of the portfolio will be invested in Treasury Inflation Protected

Securities (TIPS) issued by the U.S. Treasury. �Up to 5% of the portfolio may be invested in fixed-rate treasuries.

Up to 20% of the portfolio may be invested in fixed and floating rate securities other than

TIPS.

All securities must be rated A- or higher. Ratings are based on the lowest rating provided by Moody’s, S&P, and Fitch.

The maximum exposure to any issuer rated lower than AAA is 2% of the portfolio on a

market value basis.

Short-term investments will primarily be held in a short-term investment fund managed by internal staff. Individual holdings of securities meeting 2a-7 guidelines are also permitted

. Derivatives use must be consistent with OPERS Derivatives Policy

All securities must pay both principal and interest in U.S. dollars.

Requirements Maintain effective duration within 0.30 years of the designated benchmark.

Exhibit 2

Performance Expectation The objective of the portfolio is to meet the performance ofoutperform the designated benchmark by 15 bps per annum on a three-year rolling basis.

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Proposed Guideline Revisions Internal TIPS Portfolio

5-16-06

Objective – Outperform the designated benchmark by 15 bps per annum on a 3-year rolling basis

Objective – Meet the performance of benchmark

Maximum exposure to issuers rated less than AAA is 2%

All securities must be rated A- or higher

Up to 20% may be invested in fixed and floating rate securities other than TIPS

Up to 5% may be invested in fixed rate treasuries

Maximum Tracking Error relative to the Lehman TIPS Index is 50 bps on a 3-year rolling basis.

Maximum Tracking Error relative to the Lehman TIPS Index is 30 bps on a 3-year rolling basis.

Proposed GuidelinesCurrent Guidelines

TIPS Portfolio