In the July issue of our new newsletter, Bond Fund Intelligence, we wrote about a session at Crane's Money Fund Symposium in Minneapolis last month called "MMF Alternatives: Ultra Short, Private, SMAs," which examined the space beyond 2a-7 money market funds. Given the yield and regulatory environments, this space continues to attention from investors. Much of the discussion focused on Ultra Short Bond Funds, the primary focus of Bond Fund Intelligence, but we also discuss the growing interest in Separately Managed Accounts. Below, we reprint the article, which featured commentary from moderator Alex Roever of JP Morgan Securities; and panelists Jonathan Carlson of BofA Global Capital Management; David Martucci of JP Morgan Asset Management; and Paul Reisz of PIMCO. (For a look at the latest Bond Fund Intelligence and BFI XLS, e-mail us at info@cranedata.com and include "Sample BFI" in the Subject line.)
What are clients in this space looking for? Explained Martucci, "It's that space between money market funds and short duration bond funds. It's a pretty broad space and I think Crane has done a good job of trying to break up that segment into conservative ultra short and ultra short, which plays into how we think about the world. JP Morgan's Managed Reserves strategy is an extension of our money market fund strategy. We keep an eye on our interest rate risk and our spread duration risk and try to limit the volatility." Added Reisz, "You have individual investors that have become tired of 7 years of earning a small amount in a money market fund or bank deposits so they're looking for additional return. The key message though is they need to understand what they're buying. Communication is important. They need to understand the risks."
How is demand for this product? Stated Carlson, "The demand is picking up on the SMA side, certainly from people getting out of prime funds, and I would argue we're seeing more from people who were using bank deposits. Those assets are increasingly finding their way into SMAs as well." Added Martucci, "The asset growth in this space has been significant. As we get closer to October 2016, clients do have to consider them. The easy decision is going into 'Govie' funds. But what's the next move? I think clients are going to have to become more serious about segmenting cash. While gates and fees are a very remote situation, if you're a treasurer, you want to eliminate that from any potential outcome. So the obvious thing that I think treasurers are going to have to consider is an SMA because that is truly where you have total control of your liquidity. Is it a $200 billion opportunity? A $500 billion opportunity? That I don't know, but I definitely think SMAs are going to increase."
On the increase in demand, Reisz added, "It's a combination of things. Some investors are looking to earn a little bit more so they are stepping out of money markets. Also, if there is even a remote chance of a fee and a gate, that to a certain extent scares them. Even if there's a low probability, it's still something that they want to avoid. Government money market funds may be the answer for some, but then once rates start to go up there will be a differential. We've seen the step out. But we've also seen the step in, the de-risking in a rising rate environment."
Martucci said ultra short bond funds are well positioned. "Over the next year, this is a time for us to shine. If we can, in this ultra short space, outperform money market funds, or deliver a limited amount of volatility and still outperform over a 3-, 6-month time period, I think, as clients start to consider their alternatives come October 2016, they have to consider this strategy and give it a good hard look."
Carlson added, "I think yields always matter, not as much to some clients as others, but yields matter." Later, he commented, "If you're managing an SMA and it is longer term in nature, if you can't beat the yield on a money market fund, you're doing something incredibly wrong. SMAs benefit from being longer than the typical money market fund, lower quality, and they also have cheaper fees. So from a yield perspective, comparing net yield on your SMA to a net yield on your money market fund -- whether it's a Govie or Prime fund -- it's going to be hard to figure out a time when we're not going to look better than those funds."
Reisz discussed managing risk in the ultra short bond funds. "In managing a strategy like this, you have to careful about what could happen in terms of interest rate volatility. There may be yield seekers, but preserving principle is also going to be important. So that's where you have to think about where you are on the yield curve. Risk management is going to be key." On portfolio holdings, Carlson said, "Everybody's got Treasuries and agencies, then corporates. More and more we're seeing people being accepting of the securitized asset classes and really in the order of: first, asset-backeds; then, mortgage-backeds; and, commercial mortgage-backeds."
Martucci added, "I would agree with that. We're also seeing agency MBS come back into the mix ... and we even see CMBS starting to get more interest." Reisz commented, "We're able to invest in a broad range of sectors. We look to purchase high quality securities that have attractive, risk adjusted returns, but cannot be purchased by money market funds. It is becoming the "New Normal" for liquidity management. If you've done the research and you think that it's a company that's strong fundamentally, it's a way to add some value in the portfolio. But make sure you're well-diversified." He added, "You have to think about the liquidity profile, what kind of volatility it could it create in the portfolio, and then make sure the clients are well aware of that. Make sure they understand what you are buying because ultimately, the client is looking for liquidity and principle preservation and then they are looking for return."
How do they benchmark performance? Carlson explained, "The irony of it is, on the one hand there are a lot of benchmarks out there, but on the other hand, there are very few meaningful benchmarks in this space. For your typical SMA, maybe a year in overall duration and then you've got a very government heavy benchmark so you're really stuck with a 1-year Bill. And if you can't beat the 1-year Bill, you know you've got a real problem. What we find is most of our clients have more than one manager and ultimately the benchmark for anything we do are the other managers -- and we are their benchmark."
Martucci said, "On a quarterly basis we try to outperform a money market fund. If we deliver that, I think clients will be happy with what we're delivering. From a benchmark standpoint, we usually use a Bill-type benchmark, but again I think the opportunity cost really is staying in true cash so I think we have to consider that as we're building portfolios." Reisz added, "We keep is simple. The reason for that is, if as a default we should be protecting principal, then that is where the habitat of the portfolio needs to be. Even if a client is looking for yield, ultimately they're still viewing this as a safe investment -- a short duration portfolio that earns some yield beyond money markets that they can access for liquidity."
On liquidity, Reisz commented, "The depth is down from where it's been. There's less issuance. Treasuries are down about $600 billion from their peak, and agency discount notes are down about $500 billion. On the other hand if you look at short duration credit -- that's up. And the reason for that is that you have a lot of corporates that have been issuing further out the curve and terming out their debt. Even if it is an enhanced cash short duration portfolio, a very large segment of that will be sitting in money market like securities. So we do have a lot a lot of liquidity in our portfolios. The flexibility in the strategy is important as well. Having access to multiple sectors makes a huge difference in terms of liquidity."
He continued, "We're managing open end mutual funds, and that means that liquidity is needed every day. We need to make sure that in our portfolios we have enough to meet any need, and it doesn't matter whether it's a core bond fund, a short duration bond fund, or a money market fund. You still have to think about liquidity.... We are focused on liquidity and we stress test our portfolios [and] individual securities. We look at what could the bid ask spread be in a worst case situation. We're doing it every day and we are always focusing on what's the downside? What's the 'black swan' event? We're always looking at that because the only way you can really raise liquidity is if you're thinking about what are the risks."
Martucci added, "What this naturally does is raise the profile of SMAs. Every week we read about liquidity concerns. If you're a client and you'd rather own your own liquidity, and not be dependent on someone else potentially needing liquidity, that's a positive technical for the SMA space."
Finally, on spreads, Reisz explained, "You've always had a differential, until now, between Prime and 'Govie' and that should start to normalize. Let's say that there are short duration bond strategies that utilize the old money market rules for 90 days as the weighted average maturity -- you might end up picking up another 20 basis points or so. Let's say it's a short duration bond fund that's investment grade, half year duration -- as things start to normalize again you might incrementally pick up a little bit more yield; that could be 30, 40 basis points. If it's a two year duration portfolio, then you're talking about yields that could be in the 1.5–2.0% range just depending on the guidelines. Again, you have to communicate with clients and just make sure that they understand that. Sure you're picking up 1.5%, but you could also lose that much over a time period as well."
