In a late-cycle market where volatility and concerns about liquidity are on the rise, many investors have gone on the defensive. In the U.S., allocations to T-bills and money market funds have spiked in 2019 despite unattractive net yields. But these traditional “cash” allocations generally are not keeping pace with other short-term investments. Investors who tend to treat their liquidity allocation as a given may want to consider a more active approach to generating return within this growing allocation to capital preservation within their portfolios.
At the same time, the advent of commission-free trading across major brokerage platforms – combined with concerns over “cash sweep” portfolios at those same brokers – means that many investors are looking more closely at alternatives to traditional liquid investments.
In this Q&A, Jerome Schneider, PIMCO’s head of short-term portfolio management, and Ken Chambers, fixed income strategist, discuss the outlook for cash and short-term markets along with the important developments at brokerage firms. They suggest that investors who can tolerate a modest step up in risk may find an attractive option in PIMCO Enhanced Short Maturity Active Exchange-Traded Fund (ticker: MINT), an ultrashort bond strategy designed to provide capital preservation, liquidity, and attractive risk-adjusted return potential.
Q: In today’s uncertain and low-yield environment, many investors focus on liquidity, typically via money markets. What is the outlook for these investments, and what are the potential risks and benefits?
Schneider: Safety is paramount for many investors these days. They hold significant allocations to traditional vehicles, such as money market funds, given their desire for liquidity amid a range of uncertainties: bouts of market volatility, concerns that buoyant stock markets mask underlying imbalances, and secular disruptors such as geopolitics, trade, technology, and demographics.
In fact, this year we’ve seen more than $530 billion in net inflows to U.S. money market funds, according to the Investment Company Institute. But there’s an opportunity cost to money markets, because their returns are sourced primarily from yield – often below benchmark rates – rather than from a combination of yield and capital appreciation. Money market investors may see the relatively attractive yield levels at the front end of the curve today, but what’s important is that those yields are likely to remain structurally lower for a significant period of time. Money market funds by nature tend to demand T-bills, but the Federal Reserve is increasing its purchases of T-bills in an effort to improve overall market liquidity. While the Fed is buying T-bills, so will money market funds – but usually at less attractive and lower yields than other short-term benchmark rates, despite the net supply of T-bills (net issuance combined with Fed purchases) turning negative.
Money markets tend to be “autopilot” allocations for many investors who seek liquidity and defense. But as the economic cycle stretches into yet another year and uncertainty and volatility persist, investors may hold higher allocations to money markets for much longer than they intended (often as a result of behavioral biases). As Figure 1 shows, government money market assets increased during the past four Fed rate-cut cycles – and remained elevated for 18–24 months after the rate cuts ended. At today’s low yields, however, staying so long in money markets could mean a significant drag on longer-term portfolio returns.
One option is to shift some of those money market assets into modestly higher-risk short-term bond strategies, which are often benchmarked to three-month Libor. Looking at the performance of money market funds versus three-month Libor over those same historical Fed rate-cutting cycles (see Figure 2), we find that as policy rate cuts commenced, three-month Libor outperformed the average money market fund slightly, and as the easing cycles lengthened, Libor outperformed more significantly – by as much as 100 basis points.
Short-term bonds may rise in price and potentially maintain a high degree of liquidity in response to Fed rate cuts – and the current easing cycle may not be over should growth concerns persist into 2020. Following consecutive rate cuts at the July, September, and October meetings, the Fed indicated its current interest rate policy is likely appropriate if the economy doesn’t materially deteriorate … but that’s a big “if.” Further cuts are possible over the coming quarters if the Fed decides it must respond to a continued evolution in negative developments.
Q: How are liquidity investors affected by the elimination of ETF transaction fees by most brokers, as well as questions about yields on industry standard cash sweep investments?
Chambers: The announcement of commission-free trading across most major brokerage platforms is a watershed moment for investors. It happens at a time when these brokers’ so-called cash sweep vehicles have attracted regulatory scrutiny and become recognized as a potential restraint on investor returns. (A cash sweep is where excess cash in an investment portfolio – often resulting from market moves or transactions – is “swept” into an interest-bearing allocation, typically a money market fund.) The combination is helping focus investor attention on “cash alternatives.”
We believe the elimination of transaction costs is great for investors: It enables them to more efficiently manage their liquidity profile, shifting easily among strategies in an effort to capitalize on slightly longer-term investments. Investors historically have allocated heavily to immediate cash investments, such as money market funds or sweep vehicles. Now investors can be more dynamic. By choosing high quality, short-dated investments, they may see higher return potential for only modest added risk out of an allocation that historically underwhelmed because of the structural hurdles of trading.
Q: From an overall portfolio perspective, how do you suggest investors approach liquidity management?
Chambers: Investors should thoughtfully assess their risk tolerance within their liquidity allocation, along with their liquidity needs over various horizons (daily, monthly, annually). Often, the desire for same-day liquidity is much greater than the actual need for it.
One exercise many investors find helpful is to tier their liquidity allocation into different buckets, and then shift allocations among them as appropriate (which may be easier now that there are fewer or no transaction fees – see above). We suggest three liquidity tiers:
- Tier 1: Objectives are principal preservation and daily/immediate liquidity; often allocated to traditional cash strategies such as money markets
- Tier 2: Objectives are still principal preservation, but with an eye on strong returns to cash along with liquidity; focused on intermediate needs (next few weeks or months); often allocated to short-term bonds
- Tier 3: Objective is to grow the cash balance over the long term; focused on needs over the next few years; often allocated to lower-duration core bonds
Investors willing to take a step out from traditional cash investments (Tier 1) into an actively managed short-term strategy (Tier 2) may add attractive risk-adjusted return potential in exchange for a modest increase in risk. Investors seeking less duration or market risk may also consider taking a step in from traditional lower-duration core fixed income (Tier 3) to a short-duration strategy given the current yield environment.
Q: What is the investment philosophy underpinning PIMCO Enhanced Short Maturity Active ETF (MINT), and what is its approach in markets today?
Schneider: We designed MINT to be a conservative, active strategy with a strong emphasis on risk management. It aims to provide capital preservation, liquidity, and strong return potential relative to traditional cash vehicles. It invests in a broad range of high quality short-term instruments, actively manages interest rate exposures, and targets attractive opportunities just outside the scope of regulated money markets.
We believe active fixed income ETFs are an attractive solution for liquidity management. An active approach fosters potentially stronger yield and capital appreciation while managing interest rate risk. It also offers greater flexibility to avoid areas of potential volatility through precise yield curve positioning and opportunistic allocations to less affected sectors, such as high quality credit and mortgages. MINT is designed to offer incremental return and income potential above that of traditional cash investments with only a modest increase in risk.
We launched MINT 10 years ago, right after the global financial crisis, a time when many investors were questioning traditional money market funds not just because of their essentially zero yields, but also due to concerns over credit risk. MINT filled a niche and represented an important evolutionary step in the investment pillar of cash management and capital preservation by relying on thoughtful active management. And since MINT’s launch, we’ve seen a transformative decade in markets. From credit risks to quantitative easing to the taper tantrum to the lower-for-longer interest rate environment to the swings in market volatility, many factors have challenged investors – both savers and risk-takers.
Looking forward, our baseline outlook is for a low-growth period of vulnerability – with trade, monetary, and fiscal policy acting as swing factors – that gives way to a moderate recovery in U.S. and global growth in the course of 2020. We remain cautious on overall credit risk, and believe that short-term, liquidity-focused investments offer optionality for investors to pivot toward higher risks if and when we see a firmer foundation to the growth outlook.
Within our short-term strategies, such as MINT, this means we are maintaining a high degree of liquidity while seeking some modest income, and we’re staying near the front end of the yield curve, considering that rates have been relatively stable there recently.
In managing MINT, we take a diversified approach, looking to generate alpha by emphasizing structural opportunities present in the markets. Currently, we’re seeing a wedge in markets (see Figure 3) that may offer a structural return advantage to strategies like MINT versus money market funds due to short-term strategies’ greater flexibility to invest in higher-yielding securities beyond T-bills and short-term government securities.
Q: How has MINT performed for investors over time?
Schneider: In the decade since its launch, MINT historically has offered attractive risk-adjusted returns (see Figure 4), and we believe we have the significant resources, process, and expertise to continue to deliver attractive risk-adjusted returns for investors despite the broader market uncertainties. The innovation and evolution of MINT offers an example of how a flexible, accessible, active approach to liquidity management may provide benefits beyond those of traditional money markets.
For the most recent quarter-end performance data for PIMCO Enhanced Short Maturity Active Exchange-Traded Fund, please click on the link below:
PIMCO has been the market leader in in actively managed ETFs since MINT was launched in 2009, and MINT is the largest single active ETF in the U.S. with over $13 billion in assets under management. MINT benefits from the same time-tested investment process – the “PIMCO DNA” – that underpins all of our actively managed investment strategies, with the benefits of an ETF vehicle (now including commission-free trades at most major brokers).
PIMCO is one of the largest managers of ultrashort and short-term bond strategies, with more than $130 billion in short-duration assets under management as of 30 September 2019. Our short-term PM team was named the Morningstar Fixed-Income Fund Manager of the Year for 2015, and this year MINT was named a Morningstar Gold-Rated Bond ETF. Through many different environments, our short-term strategies, including MINT, have offered investors attractive return potential and low volatility, along with low interest rate exposure. A decade after MINT’s launch, we remain committed to its thoughtful, active approach amid the market’s uncertainties.
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