J.P. Morgan Securities released a special "Short-Term Fixed Income Markets Research Note" yesterday, entitled, "Beyond money markets: An overview of short-term bond fund strategies." The update, written by Alex Roever, Teresa Ho, and Chong Sin, says, "Short duration funds have been one of the most popular investment products over the last few years. Demand has been driven by zero rate fatigue from money market fund investors seeking higher yielding products offering principal stability and limited mark-to-market volatility and more recently, from some longer duration investors who are cautious about the potential for rising rates. In this note, we provide an overview of short duration open-end mutual fund and exchange traded fund (ETF) flows, performance, and asset allocation. We note that short duration mutual funds and ETFs are mainly retail products. Institutional investors often utilize separately managed accounts, typically using similar strategies but for which there is extremely limited data currently."

The piece explains, "Short duration funds have experienced exponential growth over the past five years, spurred on by an extended low rate environment and flood of liquidity from central bank quantitative easing. ETFs, in particular, have become increasingly popular due to their cost efficiency relative to mutual funds. While money market funds have seen returns near zero for the last few years, short duration funds have been able to return about 1% to 3%, on average, per year over the last 3 years depending on strategy while return volatility has continued to fall. Short duration fund strategies run the gamut but most funds maintain durations below 3.5 and tend to allocate their assets more heavily towards corporate credit, mortgages, asset-backed securities, US Treasuries, and US agency debt."

Roever, Ho and Sin write, "This exponential growth have been a direct result of the Fed's zero interest rate policy coupled with asset purchases, which have suppressed yields and flooded the market with liquidity, rendering cash products such as money market products unattractive from a yield standpoint. In response, many investors who value principal protection and minimal volatility reallocated their cash from money market products to short duration funds, which aim to achieve the aforementioned goals but at the same time, provide higher returns than money market products. And more recently, some concerns over rising rates have created additional demand for these products from some longer duration investors who are shortening duration."

They tell us, "The investment styles of these funds run the gamut but, generally speaking, short duration funds are those that maintain average effective portfolio durations of 3.5 and below. Using data from Morningstar, we've categorized all short duration mutual funds and ETFs into 3 categories using the following 3 simple criteria in order of importance: 1) average monthly or quarterly effective portfolio duration over the last 3 years, 2) best fit short duration index over the last 3 years2 and 3) stated primary prospectus benchmark index."

The JPM piece adds, "We note that mutual funds and ETFs mainly cater to retail investors who may have more flexibility to reallocate their investments based on market conditions whereas, institutional investors often have liquidity preferences. This is especially true in the front-end, where large pools of institutional cash have a strong aversion to principal loss and mark-to-market volatility due to the operational nature of this cash. Institutional cash that leave 2a-7 money market funds that currently provide constant NAV or commercial bank deposits often end up in separately managed accounts that aim for principal stability and minimal volatility while providing higher yields than money market products. However, transparency into this investment pool is extremely limited so we limit our analysis to observable mutual funds and ETFs whose management companies also manage much of the institutional separately managed accounts."

They also comment, "Short duration open-end mutual fund and ETF net assets totaled $383bn as of the end of 1Q13, growing by 18% over the past year. [Ultrashort bond funds account for just $58 billion of this total according to a table accompanying the article.] 3y and 5y growth were 52% and 158%, respectively. Short-term bond fund net assets experienced the largest growth in the last 3 years and 5 years at 67% and 208%, respectively. In the past year, ultrashort fund net asset growth outpaced those of others at 30%. Short-term government funds, on the other hand, lost 9% in net assets over the past year and 5% over the last 3 years given the lack of relative performance. However, its 5y growth was 34%."

Finally, the Note says, "Short duration funds have been able to achieve relatively attractive returns in spite of the extended low rate environment mainly by employing active sector rotation and reaching down in credit quality.... In an environment where yields are not easy to come by, we think asset allocation and credit quality decisions will continue to drive returns for short duration funds. We expect credit to continue to outperform as spreads, as tight as they are, still have room to compress."

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