This month, MFI interviews Morgan Stanley Investment Management Managing Directors and Co-Heads of Global Liquidity Fred McMullen and Jonas Kolk. MSIM is the 5th largest manager of global institutional money funds, overseeing $169.0 billion. We discuss the latest issues involving U.S. money market funds, and also talk about pending European money fund reforms, the state of conservative ultra-short bond funds, and a number of other issues in the cash investment space. Our Q&A follows. (Note: This interview is reprinted from the February issue of our flagship Money Fund Intelligence newsletter; contact us at inquiry@cranedata.com to request the full issue.)
MFI: Tell us about your history. McMullen: The genesis of the business was designed for our brokerage and private wealth platforms. In the early 2000s, we made a push into the institutional funds market, both in the U.S. and offshore. Then for our ultrashort fund, which is approaching its two-year anniversary, that history coincides with the recent regulatory changes here in the U.S.... I joined Morgan Stanley in 2010 and took over the distribution and product functions in 2011. I've been in the industry about 30 years. Kolk: We launched our first money fund in 1975, so it was one of the first funds in existence in the industry.... I joined 14 years ago [and] was hired as someone with experience on the institutional side of portfolio management.
MFI: What's your biggest priority now? McMullen: We have a lineup of U.S. institutional funds and retail funds in both the taxable and tax-exempt spaces, and we also have our offshore funds across three major currencies -- U.S. dollar, euro and sterling. The money market funds are complemented by our Ultra Short Income Bond Fund [where] the AUM is a little over $7 billion.... We also manage liquidity separate accounts.
I would say that EU money market fund reform is right on top of our priorities list, and where we're spending a lot of time engaging clients and firming up our product line decisions. On the offshore side, we've experienced a lot of growth.... [We're now] number six in the offshore league tables, so we want to preserve this part of the franchise as much as we can. In terms of our response to the EU regulations, we're finalizing what our product lineup will look like.... We think there's a lot of meaningful demand for the low volatility NAV (LVNAV) option, as well as the public debt CNAV fund structure, and we're trying to get a handle on if there is really scalable demand for the floating NAV option at this point. We don't see a lot of it yet, but we're doubling down on our client engagement there.
The other priority is client engagement in the U.S. following the regulatory reform. There are a lot of cash managers rethinking their investment options, given the different market environment we're in now [with] interest rates moving meaningfully higher. They want to potentially diversify their government and their deposit holdings.... We have a lot of clients that are rethinking prime funds -- that's obviously a hot topic in our market -- and also looking at the ultra-short bond fund category.... [In addition], they're focused on deposit betas as rates continue to rise.
Another priority for us is just diversifying the business further. The ultrashort funds have been a lot of help in that regard, and we're working on a number of product development opportunities. We're also developing our online capabilities. Our online platform leverages Cachematrix technology. The nice thing is it allows us to broaden our liquidity fund offerings beyond the Morgan Stanley funds. This is something that we're increasingly focused on as we move through '18 and beyond.
MFI: What's your biggest challenge? Kolk: We have an overriding philosophy of opportunistic portfolio management, but it always has to be premised on the basic tenets of safety and liquidity. You're always trying to strike that right balance, and if you have to err on the side of caution, obviously you do so. More specific to today's current environment, obviously it's the rising rate environment. The Fed raised rates three times last year. Our expectation is clearly that they're on a similar path this year so we're managing against that backdrop.... What does that mean from a portfolio management or portfolio construction standpoint? You have to be very focused, very disciplined on how you build out your maturity ladder. You have to pay attention to final maturities of fixed rate paper and reset dates of floating rate notes.
MFI: What are you buying? Kolk: It's a very benign credit environment, but those are the times that you have to have a more heightened sense of awareness.... I think you always have to be very vigilant on the credit side, and that's something we spend a tremendous amount of time on. We're always focused not only on fundamental credit risk but clearly headline risk; we're not buying securities from areas of the world that we think might lead to an increased incidence of headline risk.... [Given the rate environment], we're fairly well overweight floaters at this point, predominantly Libor based. Libor is a really cheap index right now.... I think in the rates funds, T-bill floaters are interesting right now as the 3-month bill starts to price in a little bit of that Fed hike premium.
MFI: Can a Govt fund be too big? Kolk: Fortunately, the government, and Treasury funds for that matter, operate in a space that is the largest and most liquid in the world, so I think that the benefits of being large in that space far outweigh any potential or perceived scarcity of securities in the marketplace. I think it's a fairly easy space to get invested in, and I think scale is something that clearly is beneficial. As you're out in the marketplace marketing a fund, we have and we pay attention to how much of a fund any one client holds as a percentage of the fund, and clients do the same. [On the debt ceiling], fortunately, it's an exercise we've been through over the last handful of years. You clearly try to limit exposure to the perceived areas that could come under pressure.
MFI: What are customers saying? McMullen: They're certainly focused on, and have noticed, higher rates, and they're growing more sensitive to fund rates versus deposit rates.... I don't see a lot of client concern around the impact of rising rates from a risk standpoint, given the Fed's current approach of 25 [bps] at a time.... In general, we've seen less client focus and concern on the EU regulatory changes.... I think the general talking point across the industry is that this is not going to be a major event.... They are focused on their plans related to repatriation. We are already starting to see some [assets] moving around, being rehypothecated back to the U.S.
MFI: What about fees? Kolk: With most of the AUM now concentrated in [government] rates funds, it's become a more yield sensitive market. A lot of clients see very little differentiation between the major government fund providers outside of yield. So you can have a significant impact on AUM as a result fees. Potential fee compression is probably one of the most important issues facing the money market fund business.... I think the good news is we're not talking about yield floor waivers, they were the worst kind. Overall, the pressure [on fees] is not up, it's down.
MFI: Talk more about Ultra Short Income. Kolk: First of all, being a bond fund and not a money market fund ... it does not follow the money market fund rules, SEC Rule 2a-7. As a result, it has a different risk profile than money market funds. We're very clear with clients on that point.... The objectives are to maintain liquidity and preserve capital while generating income.... They are similar to prime funds in that ultrashort bond funds have floating NAVs, [but] no liquidity trigger-based gates and fees.
What's really important too is that ultrashort funds can vary meaningfully in terms of their portfolio strategy permissible investments, duration, etc. We constructed our fund to be on the very conservative side of the category. For example, it has a max WAM of 90 days and a max WAL of 180 days, which of course is different than money market funds. It's basically a fund that's comprised of plain vanilla money market securities.... You can add a little bit of incremental return but not significantly alter the risk profile.
MFI: Who invests in the ultrashort? McMullen: Size is an issue in terms of attracting institutional investors. We've seen a lot of interest, and we have a number of institutions that have come into the fund. So, it's a nice mix of institutional and high net worth clients.... It's definitely getting meaningful traction in the institutional space, and as it gets bigger we would expect that start to accelerate.
MFI: Any thoughts on H.R. 2319? McMullen: We don't have a public stance on that, but it's not something we focus on and it's not something we find clients talking about.... I think if clients supported that and were more interested in that, I think we'd have a deeper interest.
MFI: Is brokerage still a big investor? Kolk: It's an important part of the business. It doesn't represent anywhere near a majority of the assets -- the bulk of our book is the institutional client base. But there certainly is a need and demand on the brokerage side ... for money market funds, and we see that continuing.
MFI: What's your outlook for 2018 like? McMullen: I'm definitely optimistic, but it's a cautious optimism. Part of that is due to the good industry AUM growth we saw in the latter half of 2017. But there are a lot of crosswinds.... I think the Fed hikes should be additive [but] repatriation is probably a net detractor in the medium term. There's a lot of talk and we see a lot more deal flow and increased M&A, and that has certainly been positive for funds. I think risk off/risk and the EU regulatory changes are big question marks. In terms of prime funds, I think you're talking about a slow grind higher, and we expect to see steady growth in the ultrashort space.
