This month, we interview Morgan Stanley Investment Management CIO & Co-Head of Global Liquidity Jonas Kolk and Global Head of Liquidity Products Scott Wachs. We discuss MSIM's Ultra Short Income Fund, which recently broke above $15 billion in assets and had its 3-year anniversary, and talk about the fund’s history, its investment strategies and a number of other topics in the “beyond cash” space. Our Q&A follows. (Note: The following is reprinted from the June issue of Money Fund Intelligence, which was published on June 7. Contact us at info@cranedata.com to request the full issue or to subscribe.)
MFI: Tell us about the Firm's history. Kolk: We were one of the first in the money market business, launching our first fund in 1975. Given our history and some of the dynamics that we’ve gone through from a regulatory, and rate, standpoint, we viewed the ultra-short bond space as really a natural addition to our business. We thought that the conservative ultra-short space was a perfect opportunity to leverage our core capabilities and extend our product line.
MFI: Talk about MS Ultra Short Income. Wachs: The fund itself is by design a very, very conservative fund on the conservative end of the ultra-short fund spectrum. It's focus and objectives are very familiar to conservative liquidity investors, namely capital preservation, liquidity and yield. But we think the fund is very differentiated in the space for a number of reasons. One is the high credit quality of the portfolio. The investments in our fund are limited to high-quality money market instruments. Ninety-five percent of the portfolio holdings must be rated A1-P1, which is of course the highest rating for short-term obligations. Also, as important as what the fund can invest in is, what it cannot invest in. For example, our fund cannot invest in derivatives or high yield securities and it can't invest in mortgage-backed securities, all of which a number of ultra-short funds can and do invest in.
A distinguishing factor of the fund is its short duration profile. Ultra-short funds can have weighted average maturities of up to a year, and many of them do. Our fund's maximum WAM is 90 days and its maximum weighted average life is 180 days. It also has a maximum maturity of any security of 397 days. This is a very short duration profile. These characteristics that I just described -- the high quality investments, the short duration profile, etc. -- this very conservative investment approach and has to date resulted in very minimal fluctuations in its NAV. Of course, it's a bond fund, so it does have an NAV that floats. But to-date it has floated very, very minimally. The volatility as compared to the competition is extremely low.
Another important characteristic that differentiates us is who we have managing the fund. Jonas's team is a specialized and very experienced liquidity team that also manages our large money market fund complex. A lot of funds in the ultra-short space are managed by a broader fixed income team. Jonas and his team's entire focus is on the very short end of the market and on very short-term money market type securities. As part of their DNA, they are also very focused on preservation of capital and liquidity.
We also think that investors, particularly in this space, are extremely interested in transparency. So we are very focused on transparency. That's best evidenced by how often we make our holdings reports available. While many competitors in this space make their holdings available monthly, we make ours available on our website on a weekly basis. I think this approach has resonated well with investors of many different types -- those that are seeking incremental yield from their liquid investments without stretching. In terms of your question, 'What are you happier about, breaking $15 billion, which is a great milestone, or hitting the three year anniversary?' I guess both.
Kolk: We are obviously proud of the track record and the performance of the fund, and we now have a 3-year demonstrated history. We're also very proud of bringing in $15 billion in AUM. When we were thinking about what type of product to bring to the marketplace and brainstorming what the product would look like, we identified a gap in the market. If you told us then that three years forward we’d have $15 plus billion in AUM, we would have viewed that as an excellent result. The fact that we reached that is a testament to the concept, and how very well received this product has been in the marketplace.
As you launch a fund and you think about how you can attract AUM to that fund, you have to get to a certain scale. You have to get to a certain critical mass, particularly on the institutional side of that marketing effort, for those institutional clients who pay attention. If they're going to invest they need the fund to be of a certain size and scale so their investment does not occupy too large of a percentage of the overall fund. So, they really do go hand-in-hand.
Wachs: As we were thinking about coming out of reform, we were pretty confident that you were going to see a huge transmission of AUM out of Prime and into Government funds. And that's what happened. Against that backdrop, we wanted a fund that filled that void and was able to capitalize on some of those supply demand imbalances. We wanted to do it in a construct that was familiar to potential investors. So, creating a fund with all those characteristics was really key in having the success that we've had. If you think about the conceptual leap ... to move into this fund if you were an investor ... it's a small step; it's not a giant leap. Since this is a bond fund, it's not subject to the fees and gates that a Prime money market fund is subject to now under the new rule. That is also an important component for some investors.
MFI: What is your biggest challenge? Kolk: On the investment side, it's not finding enough product to buy. This is happening because of the macro outlook, the interest rate environment. It's happening particularly of late with the Fed pivot and going from a regime where you're actively pricing in Fed hikes to a regime where the Fed's really done a 180 and tightening is off the table. The Fed's communicated a pause, and now the market is starting to get really worried about some macro factors, whether it be China, trade and global growth, Brexit or tensions in the Middle East. You've rapidly gone from one Fed policy stance to a market that's pricing in a significant amount of easing at some point in the not too distant future. The biggest challenge on the investment side is managing all those different crosscurrents from a macro standpoint and navigating the changing interest rate environment.
Wachs: On the client side, it's really educating the market on the investment guidelines of the fund. What we invest in is very familiar to liquidity investors. It's a very familiar investment universe and a very familiar in-depth approach. It's just beyond a money market fund, so it shouldn't be a big step in terms of what this fund does and what this fund doesn't do.
We also face a challenge particularly with institutional clients, in terms of 'What does their investment policy say about what they can invest in?' Can they invest in ultra-short bond funds or conservative ultra-short bond funds? Do they need to make amendments to their investment policies to be able to invest in this type of fund? The fact that the fund has similarities to what is in clients' investment policies, which has been helpful in building a case internally to add this fund to their investment policy.
MFI: What do you buy that money funds don't? Kolk: It's at the margins, a little bit here and a little bit there. We do have a small allocation to some A2-P2, Tier 2 credits, because they're great diversifiers in the portfolio. Much of what's issued in the very front end of the money market space is financial. So in that Tier 2 bucket, we're doing largely brand name corporates.... We do not view them as lower credit investments, they just happen to be lower rated because that is where they choose to be in their capital structure. From an investment perspective, they give us the ability to better diversify the portfolio.
The other main place that that you see differentiation and that we are able to add some alpha is at the portfolio level. We can have slightly longer weighted average maturity and weighted average life, so we pick up a little bit of incremental yield there without changing the overall risk profile of the portfolio. We're also utilizing nontraditional repo and term nontraditional repo in some creative structures that we can add yield over similar unsecured investments. As a bond fund, you're obviously not subject to the fees and gates regulations that are part of the 2016 reforms. As a large, very well diversified bond fund with both a retail and institutional shareholder base, we don't need to hold the same degree of daily and weekly liquidity -- either from a regulatory or from just a fiduciary prudence standpoint.
MFI: What about your outlook? Kolk: Because of the way we structured this product from both an investment guidelines and an investment process standpoint, it's a fund that has a tremendous amount of versatility. It's also a fund that should be attractive and consistent across interest rate and credit cycles. We have a great proof of concept in terms of how the fund performed from a yield and a volatility standpoint in 2018. Particularly in the fourth quarter where you had hikes throughout the year and a fairly dynamic market in terms of volatility and spread widening.
I think that the fund performed exactly how we wanted it to and anticipated it would. If you extrapolate that out to a flat interest rate cycle or a cycle of declining interest rates, this as a fund that has a lot of versatility and a lot of consistency across credit and rate cycles. Wachs: To be able to have a fund of significant size and scale in all of the important cases in the broader liquidity space is very advantageous and is appreciated by our clients.
