This month, Bond Fund Intelligence speaks with Morten Olsen, Director of Ultra-Short Fixed Income at Northern Trust Asset Management. Olsen oversees Northern's ultra-short bond fund lineup, including the $2.1 billion Northern Ultra Short Fixed-Income (NUSFX) and the $3.5 billion Northern Tax-Advantaged Ultra-Short Fixed-Income (NTAUX). We discuss fund strategies, rates, risks and the future of ultra-short bond funds below. Olsen expects a very busy 2017 for the sector. (Note: This "profile" is reprinted from the March issue of BFI. Contact us if you'd like to see the full issue.) Also, thank you to those who attended our inaugural Bond Fund Symposium in Boston, which attracted over 150 participants!
BFI: How long have you been running ultra-shorts? Olsen: Northern Trust has been running ultra-short strategies since the late 1980's. Ultra-short is part of our broader liquidity management capabilities at Northern Trust Asset Management, which currently total approximately $225 billion in AUM. Our liquidity management capabilities include government and prime money market funds, as well as ultra-short strategies. Common across all these strategies is our conservative investment approach, which focuses on credit research and risk management. I have 13 years of experience in the fixed income industry. I joined Northern Trust back in 2009 in the London office, and in May of 2016 I took over as director of ultra-short based here in Chicago.
BFI: Tell us about the funds. Olsen: We have two mutual funds. They were started back in 2009 and have a combined AUM of $5.5 billion. The two funds differ in their strategies, and therefore attract a different client base. The taxable mutual fund focuses on corporate bonds and on Treasury securities, and the tax-advantaged fund focuses mainly on municipal securities but will also add corporate bonds.... The tax-advantaged strategies will only add corporate bonds when the after-tax yields of these are favorable compared to a tax-free municipal bond.
Olsen: Ultra-short falls under our cash segmentation strategy, which is a way for our clients to bucket their cash. The three buckets are: operational cash, which is for day-to-day needs -- a client should typically be investing into a government fund for this portion; reserve cash, which is for intermediate needs -- this portion should be invested into a prime money market fund; then the last bucket, strategic cash. That's where ultra-short really becomes interesting. Strategic cash has a horizon of up to 6 to 18 months, and using an ultra-short strategy is a way for our clients to earn a bit higher yield while only taking limited additional risk.
BFI: How has the reception been of late? Olsen: Over the last couple of years, ultra-short has become extremely popular, not only at Northern Trust. Money market fund reform certainly played a big part in the growth we saw last year, and it still does. But the market that we've been in the last 7-8 years, with close to zero interest rates, meant that investors were looking for additional yield. Ultra-short played nicely in the search for higher yields and our conservative approach resonated well with clients. They know that we never compromise our risk management practices when we search for higher yields. When I look at the asset growth for our ultra-short business, we have seen significant growth last 5 years. We now manage close to $20 billion across our whole ultra-short business.
BFI: What's your biggest challenge? Olsen: Fixed income investors face some significant challenges at the moment, but it's important to remember that challenges often open the door for new opportunities. A good example of that is the potential for a more active Fed in 2017; that's certainly a concern for most fixed income managers at the moment. No client likes to see negative performance, which could be the consequence of higher rates in the short term. That is, I would say for us, the biggest challenge for us at the moment.
The way we've been trying to deal with this is to position our portfolios a bit shorter in duration. We've also made a big effort to get in front of our clients and talk about the consequences of higher rates. The flip side of higher rates and the short-term negative effect on performance is the fact that, as an investor and as a portfolio manager, you start investing into higher yields. The floating rate notes that we have in our portfolio will start resetting at higher rates. With higher rates we often see a steeper yield curve as well, something that's welcomed by fixed income portfolio managers.
BFI: What kinds of strategies can and can't you use? Olsen: Compared to a money market fund, we do take additional duration risk. A typical ultra-short fund will target duration anywhere between 6 and 18 months. The other big difference between an ultra-short fund and a money market fund is the fact that we will utilize the full investment grade spectrum. Then looking at the other side and comparing us to how long bond funds tend to invest, ultra-short funds certainly will have a much larger allocation to floating rate notes. We tend to set a final legal maturity on our bonds. An ultra-short fund typically won't invest further out than 5 years for a floating-rate note and 3 years for a fixed-rate note.
A conservative approach is certainly one of our main messages to our clients. That's why we've decided not to add any high yield bonds into our portfolios. We don't add any derivatives. We don't add any cross-currency securities into our portfolios. We want to be straightforward in our approach to investing. One other point to highlight when we talk about our conservative approach is our diversification and our issuer concentration limits. We have plenty of clients that are comfortable with a 5% allocation to a credit. But we don't think that is appropriate. So we've set our own internal credit risk management limits much lower.
BFI: What sectors does the fund buy? Olsen: It's always been one of the worries about money market funds -- the high concentration to financial securities. One of the advantages of being in an ultra-short fund is that you have better diversification. We set our overall industry limits at 25%, so we will not have more than 25% exposure to financial securities within our mutual funds. So that leaves us with 75% of something else. On average, we probably have 15% of allocation to Treasuries. The rest of the portfolio is diversified between corporate bonds and triple-A rated asset-backed securities. Then in our tax-advantaged funds, we obviously have a fairly high allocation to municipal securities. But here again we will diversify across different sectors. We have some clients who specifically ask us to only buy U.S. bonds, and we can still produce a fully diversified portfolio.
BFI: Do you do separate accounts? Olsen: We do have a pretty large separately managed account business within ultra-short. If you look at our overall AUM at roughly $20 billion, the two mutual funds are roughly $5.5 billion [vs.] nearly $15 billion in separately managed accounts. These accounts tend to be preferred by our larger investors. They really appreciate our flexibility in creating guidelines and portfolios that match their risk appetite. That's why, prior to opening any new account, we will spend a considerable amount of time with our clients. We sit down and talk to them to understand their constraints, their liquidity needs, and really understand their risk appetite. That's really the number one advantage of the separately managed accounts -- the flexibility you can offer your clients.
Our FlexShares Ready Access Variable Income (RAVI) exchange-traded fund launched in 2012 and follows the same guidelines as our taxable mutual fund. The big difference is that we target a shorter duration in the ETF. We mainly do this to limit the price fluctuation. While the mutual funds tend to target duration of up to 1 year, the ETF will be much closer to 6 months. Hence the ETF will have a higher allocation to money market securities than our mutual fund.
BFI: Will rate increases impact you? Olsen: Absolutely. If the Fed is successful in raising rates slowly, ultra-shorts certainly benefit. We like slow increases in rates due to the higher reinvestment rates. We spend a lot of time with our clients to remind them and tell them up-front that ultra-short funds do have risk, although it is limited. It's important to know that an ultra-short fund is not for day-to-day liquidity. There will be fluctuations in the NAV. If your investment horizon is shorter than 12 months, ultra-short is probably not the right product.
BFI: Can you comment on regulations? Olsen: The biggest regulatory change, although it didn't directly impact ultra-short funds, was clearly money market fund reform. It meant two things for our market. We saw investors move out of prime funds into government funds. But it also meant more flows for ultra-short funds. The second effect was mispricing of some money market securities [which had] yields that were much higher than expected. That was certainly something that we took advantage of in our ultra-short funds.
BFI: Tell us about your investors. Olsen: Historically our client base was very much driven by our wealth management business; almost 100% of our clients came through that channel. But over time that has evolved. So when I look at our client base right now, I would say roughly 50% are still wealthy, private individuals. But the other 50% are institutional clients. What made me really excited about the growth we saw in 2016 was that the interest for ultra-short came through both client channels.
BFI: Any thoughts on the future? Olsen: We're really positive about the future of ultra-short. I don't think the effects of the money market reform have fully played out yet. I still think we'll see plenty of interest from clients that are looking for something other than a prime money market fund.... The fact that the rates are going up also opens up ultra-shorts for another type of client -- those that are currently invested in longer duration bond funds. As rates move higher, ultra-short is a pretty powerful strategy to shorten your duration, keep your overall asset allocation in fixed income but decrease the effect of higher rates by shortening your duration. So we're really excited about the next couple of years, and we expect to be really busy in 2017.
