This month, BFI interviews Fort Washington Investment Advisors' Managing Director & Senior Portfolio Manager Scott Weston and Senior Portfolio Manager Laura Mayfield. Fort Washington is the investment subsidiary for Western & Southern Financial Group, and manages a number of funds for Touchstone Investments. Touchstone recently announced the launch of a new Touchstone Ultra Short Income ETF. Our Q&A follows. (Note: The following is reprinted from the August issue of Bond Fund Intelligence, which was published on Aug. 12. Contact us at info@cranedata.com to request the full issue or to subscribe. BFI is $500 a year, or $1,000 including our Bond Fund Intelligence XLS spreadsheet.)
BFI: Give us some history. Weston: Fort Washington's Ultra-Short Duration composite was incepted in 1995. So, we've been in this ultra-short space for about 27 years. I started at Fort Washington in 1999 and in 2001 Brent Miller and I assumed management of the ultra-short composite and began migrating it from a credit-only focus to a multisector focus with an emphasis on structured products. We had a strong conviction that the ultra-short duration markets were inefficient and structured securities provided a consistent source of alpha in this part of the curve. We believe this value proposition holds true.
We assumed management of the Touchstone Ultra Short Duration Fixed Income Fund in 2008. At the time, it was a government-focused strategy. Then in 2010, the Fund's directors changed the Fund's focus to a multisector strategy, allowing us to fully execute our ultra-short duration style of investing. The allocation to structure typically ranges anywhere from 50% to 70% of Fund assets - we expect the ETF to be similar.
BFI: Tell us about the new ETF. Mayfield: Touchstone Investments is launching four ETFs here in a short timeframe. These are the first ETFs for Touchstone, the Touchstone Ultra Short Income ETF being one of them. The thought process is pretty simple. We've seen that there's strong demand for ultra-short duration strategies in ETF form. Our mutual fund, Touchstone Ultra-Short Duration Fixed Income Fund, has a really strong track record, and it compares favorably to some of the ETF managers that have been successful in garnering assets in the ETF space for ultra-short duration. Our investment process is consistent and repeatable, so it makes a ton of sense for us to launch this strategy in ETF form.
BFI: How is the ultra-short sector faring? Mayfield: It has been a challenging year for the space overall. Our strategy has held up really well. The Morningstar Ultra Short Bond category average is down more than a percent over the past year, which is a lot for Ultra Short. But it's still a very safe haven compared to Core Fixed Income or longer-duration strategies. If you look at the Bloomberg U.S. Aggregate Index, it's down 10% for its 1-year trailing return at this point. You just had the perfect storm of a historically severe shock to rates, and then significant spread widening on top of that. There aren't a lot of ways for fixed income funds to produce positive returns in that type of environment, and not many have.
So, for us, our portfolio construction process is designed so that the portfolio generates significant organic liquidity to meet redemptions, and that minimizes the risk that we're ever forced sellers in this type of environment. That's exactly why we designed it that way, and that approach has really paid off for us. Over the past year and a half, the funds who've been forced sellers in this environment are locking in mark-to-market losses, whereas our shareholders should benefit from the full recovery in the securities we hold, even to the extent that there's negative mark-to-market volatility. We're holding those bonds to maturity and they're going to get paid off at par. We don't have credit concerns about the ability to get repaid at par. When you look at the carnage out there across fixed income as a whole, ultra-short duration has really been a safe haven on a relative basis, and we're really proud of how our track record has held up.
BFI: Discuss the ETF vs. the fund. Mayfield: The investment philosophy and the process will be identical, but the ETF is designed to have a little bit higher risk-return profile than the mutual fund. So, the ETF allows for up to 15% exposure to below investment grade securities, whereas the mutual fund vehicle is investment-grade only. We've always thought the mutual fund caters to investors who [are] 'inside-out' investors, meaning that they are traditional cash or enhanced cash investors that are extending out into ultra-short duration to pick up a little bit of additional yield. We know that they are highly sensitive to volatility and capital preservation, so we manage the strategy accordingly. That won't change with the ETF. It is just going to have a little bit higher risk-return profile than the mutual fund, but within that framework.
BFI: What are you buying? Mayfield: This is a great environment to be putting money to work in the ultra-short space, and we're really excited about the opportunities that we're seeing right now. There are plenty of things that we're cautious about, namely inflation, recession risk, the Fed, all of those things. But we're seeing some really attractive risk-return profiles out there, especially in structured products. We are stress testing bonds through any number of scenarios, and we've been able to add bonds with really attractive yields to the portfolio with solid credit profiles that we expect to hold up in spite of all those risks and stresses.. So, we've been especially active in different segments of the ABS market, as well as RMBS, CLOs, and CMBS.
BFI: Does the advisor market drive ETFs? Weston: It's a retail product and that's what we're hearing as well - the FAs like the product. They like the lower fees, the higher returns, and the tax efficiency - it works well on their platforms. Some FAs cannot use the mutual fund on their platform, but they can use the ETF. So, it appeals to a broader investor base.
BFI: Tell us more about the base. Weston: We've got a pretty healthy mix of investors in the mutual fund. If you look at the distribution across the various share classes, you see about one third of the investor base in the institutional share class. The other two thirds are retail investors who tend to be concentrated in the lower fee share classes. We expect that the ETF will have a similar distribution.
BFI: What's the outlook going forward? Weston: I think the challenge that the ultra-short space had at the beginning of Q4 last year, when rates started rising, was that there was just no yield. Historically, yield has been the buffer, or the anchor, that produced stable returns in fixed income portfolios - for core-fixed, for ultra-short, for any fixed income strategy. Yields were just very, very skinny and as a result, we've seen challenging returns year-to-date. But, since rates started rising in Q4 last year, we're up about 300 basis points in the one-year part of the curve, and credit spreads have widened substantially - spreads in some sectors have doubled or tripled. So, we're in a much better place today - the weighted-average gross market yield on the fund is now over 4%.
As Laura noted earlier, we're seeing some very good opportunities in the ultra-short space. So we think it's an attractive time to be thinking about the strategy. This core yield should help buffer the rate spread and volatility that we anticipate as the Fed and the markets wrestle with inflation and the prospects for a soft landing. So, if the Fed's rate forecast, or Fed funds futures market, are close to being right, we think that bodes well for the ultra-short space and we should generate positive returns for the remainder of the year.
But given the uncertainty that we face, with the outlook for inflation and potential recession, we're playing it pretty close to the vest. We're shorter duration and we're maintaining an upward quality bias. We think that's going to be key to managing risk and generating positive returns for the remainder of the year.
