From the August 2013 issue of Investment Advisor • Subscribe!

July 29, 2013

An Ultra-Strong Case for Ultra-Short Funds

Pioneer Investments’ Charles Melchreit makes a strong case for a skeptical space

Photography by Webb Chappell. Photography by Webb Chappell.

It’s been a tough road in the ultra-short mutual fund space. The category blew up in 2008 along with everything else, and yields proved little better than money market funds in the recovery that followed.

“We don’t cover many of these funds anymore,” said Sarah Bush, senior mutual fund analyst with Morningstar. “Ultra-shorts were yielding too little and got really small, and we just felt we needed to deploy our resources elsewhere.”

But when Bush took a second look, she found a surprise.

“The category has experienced modest inflows really since the beginning of the recovery in 2009,” she explained, adding that this includes the massive bond fund outflows seen in June. Floating rate funds were the only other category besides ultra-shorts to zig when all else zagged during that month.

The good news may be due to the fact that some of the funds “aren’t around anymore,” or were rolled into other funds and subject to survivorship bias. Whatever the reason, Charles Melchreit sees a strong argument for their inclusion in client portfolios.

“There were some lessons learned from several years ago,” said Melchreit, manager of Pioneer Investments Multi-Asset Ultrashort Income Fund (MCFRX). “What happened at that point is that ultra-short funds were really directed at grabbing for yield without taking adequate notice of the risks they were incurring. They essentially became overly concentrated in higher-risk, longer-weighted average floating rate mortgage securities.”

Calling them “a one-trick pony at that point in the cycle,” they chased yield without properly disclosing the accompanying risk, he claimed. “The new generation of ultra-short funds is a little bit different. There is clearly much better disclosure and transparency as far as the risks that are being taken within the fund. We’ve seen a lot of funds launched in this space recently, and everyone is very clear with their investors as to where the risks are.”

He emphasized that they aren’t “a $1 NAV type of fund” (read: money market).

Pioneer’s ultra-short fund, which Melchreit co-manages with Seth Roman and Jonathan Sharkey, is “massively diversified” in that it hits a lot of different levers at Pioneer across a lot of different sectors.

“I don’t think that’s as unusual now as it once was within this space. We’re looking to invest in sectors that are not terribly correlated. Most sectors have some correlation, but we’re really trying to take advantage of any imperfect correlations that we can in the short duration space.”

The fund has a heavy focus on risk management and trying to manage NAV volatility so it doesn’t experience massive swings.

“I think another lesson learned in 2008 is that one has to diversify one’s sources of liquidity, particularly in an ultra-short fund that may see significant outflow activity in certain market scenarios. There were a lot of people heading for the exits at the same time [during the economic crisis]. The ultra-short world is now using a lot of different sectors in corporates and mortgages and even bank loans, money market instruments and cat bonds, all of which appeal to different investors and present for us as an investment manager different pools of liquidity.”

Meaning if faced with a period of high redemptions, he has a choice of which securities to sell.

Great—so what role will ultra-short funds therefore play in a client’s portfolio?

From speaking with advisors, Melchreit said it’s a good strategy for investors “looking at a longer-term allocation to cash.”

“We tell people these are not appropriate strategies for people who need a checkbook,” he warned. “If people need to be in cash for a month or two because they have some money for a closing on a house or making a tuition payment, this isn’t the place to be. Rather, if they have a 10% or 20% allocation to cash because they’re defensive or they’re looking for better entry points into the equity or fixed income markets and they don’t want to earn zero in a money market fund, then an ultra-short fund makes sense.”

He said he tries to evaluate the odds that it will outperform a money market fund over a certain holding period; the longer the holding period, the greater the probability it will happen.

“There will be very few scenarios over a four-, six- or 12-month horizon where the yield is not sufficient to offset a drawdown in the NAV should the market go against you on the asset side,” he noted. “That’s basically the kind of discussion I’ve had with advisors. It seems to be a fairly appealing story for them; they see it as a long-term parking place for cash.”

Melchreit’s previous mention of money market funds brings to mind how they “broke the buck,” and the alternative products that grew in popularity as a result, namely stable value funds. How do ultra-short funds compare?

Noting that a number of products offered low risk but no yield, he believes there is a market for a fund with low interest rate exposure like the aforementioned floating rates funds, but with higher-quality investments.

“With stable value funds, you won’t see the adjustment in the yield that you would see on an ultra-short fund,” he said, hence the name “stable value.” “Our ultra-short fund manages very strictly to its benchmark of three-month Libor. That means that if you have a scenario where rates are rising, the yield on this fund by virtue of the assets in which it’s investing will rise fairly quickly, along with short-term market yields.”

A stable value fund, on the other hand, tends to have a “longer runway” because they’re typically investing in two- to five-year securities.

“They will give you a credited rate, which does not adjust as quickly,” he argued. “I would add you have less transparency in how the rate adjusts over time. Not all stable value funds will adjust upward as rates rise.”

Melchreit noted the fund is modestly defensive going into the second half of the year, in keeping with his comments about managing the strategy for low NAV volatility. Unlike a traditional intermediate bond fund or total-return-oriented fund, it does not make big sector reallocations based on outlook. Rather, it runs “sleeves” in different asset classes that are fairly stable to help with risk mitigation and diversification.

“In that sense I guess we always run defensively,” he quipped.

Asked for closing comments, Melchreit urged advisors not to believe the hype and (once again) emphasized the risk management aspect that not only he, but other managers in the space, are sticking to.

“Very diligent risk management has become deeply embedded within the portfolio management process. I think it’s an attractive strategy now for investors, and I don’t think they should be dissuaded by some of the bad press that this type of product had several years ago. I think the industry has learned its lesson and responded appropriately by designing better ultra-short strategies for the investor.”

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The print version of this article indicated the fund had holdings in cap funds rather than cat bonds. This version has been updated with that change.

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