Institutional investors are paying too much for the liquidity provided by a money market fund and are failing to realise that they could reap higher returns without adding incremental risk.

According to John Donohue, chief investment officer of the London-based fixed income group at JPMorgan Asset Management (JPMAM), corporate treasurers could earn an extra 30-35 basis points by investing their longer-term cash in low volatility enhanced cash funds.

“There is a cost to getting daily liquidity and stable net asset value,” says Mr Donohue Investors are paying for that in yield. We have seen some move towards enhanced cash funds but not as much as it should be given the risk-return profile of these vehicles. They are still very safe.”

He contends that investors have not taken the time to understand how enhanced cash funds are structured. Having said that, he warns that enhanced cash is a very broad universe and investors need to know how a manager is running the fund and achieving the targeted alpha.

Mr Donohue notes that in the absence of a regulatory body to police their actions, money market funds in Europe have been investing in two- and three-year asset-backed securities (ABS) in a bid to enhance yield.

“In the US, the Securities and Exchange Commission regulates money market funds. In Europe, there is no governing agency which lays down a standardising set of criteria for money market funds,” contends Mr Donohue. Investing in ABS is risky for money market funds because they are supposed to be providing stable net asset value and liquidity. Instead, they are taking on spread duration that might not be appropriate. This dynamic has been going on in Europe for some time and it has had a big impact on the European ABS market in terms of tightening spreads.”

Tight spreads

But he notes that while the spreads on European ABS have become very tight, these securities still trade at swaps spreads plus for an AAA-rated security with structured protection from credit enhancement or liquidity. “We would always prefer that risk to an agency or a non-corporate credit that is trading through swaps spreads” he adds.

With $35bn under management in international liquidity funds, JPMAM claims to be the largest institutional money market fund manager in the world as well as the largest global money market fund manager in the world.

But while Mr Donohue oversees some $200bn managed by the global cash and global short-term investment teams, much of his focus is currently directed at the on-going integration of JPMAM’s London and New York fixed income investment teams.

Pointing out that London-managed fixed income assets have doubled over the last four years to $28.3bn, the aim he says is to establish specialist investment teams in the UK similar to those which have been in place in the US for the last three years.

Mr Donohue explains: “In the UK, we have not made that move to specialisation to the extent that we would have liked. I want to integrate the London and New York fixed-income investment teams into a more cohesive, effective global investment engine.” He maintains that the specialist investment model offers the best means of capitalising on growth opportunities in fixed-income internationally and adds that JPMAM will consider developing new expertise in sectors not already covered if deemed necessary.

“As the global opportunity set becomes more complex, no one single individual can be an expert in all the various fixed income sectors. So that is why we want to align sector teams with specific opportunity sets across the globe,” he observes.

Of JPMAM’s 18 specialist fixed income investment teams, 11 are based in New York. Sectors covered include mortgages, corporate bonds, ABS, government/agency debt, real estate debt, high-yield bonds, non-dollar international debt, short-term debt and emerging market debt. The remaining seven fixed income sector teams are housed in London, including specialists in global interest rates, MBS/ABS, corporate bonds, emerging market debt, foreign exchange and cash management. There is also a team which works across all the aforementioned sectors.

JPMAM has created what Mr Donohue calls “centres of excellence”. For instance, the MBS investment team in the US is responsible for all of US mortgage allocation across JPMAM’s entire book of fixed income business internationally.

The development of the specialist investment structure is also being driven by institutional investor demand for more aggressive sources of alpha, particularly in the current low return environment for fixed income.

“Absolute return products and portable alpha are in demand and you need to have expertise in all of the sectors in order to deliver the expected returns,” explains Mr Donohue. With our specialist teams we are able to port the alpha derived from swaps, futures and options. Given that you can replicate a lot of indices using futures and derivatives with low transaction costs, it is very easy to replicate the beta for the client and port whatever alpha they want from your various sector teams. You cannot do that in a generalist model. It does not lend itself to that type of alpha generation.”

Mr Donohue says that the specialist investment model will also help the firm to capitalise on the trend for investors to parcel out their fixed income allocation to a number of different specialist managers, instead of selecting a single manager to run a multi-sector strategy.

“We wanted to make the move to true sector specialisation in London. We wanted to be in a situation where we have the expertise in all of the sectors and so get the opportunity to win as many sector-specific mandates as possible. We have completed that move now and the next step is to deliver to the market new more innovative and aggressive products to meet the demands of European investors for more alpha.”

So JPMAM is planning to launch a new liability-driven investment strategy this year. Mr Donohue says it will be a pooled fund with the ability to port alpha and the flexibility to meet different liability streams.

The firm is also planning to roll out a “highly aggressive” total return European bond fund which will target a return of 250 basis points before fees above the Lehman Brothers Euro Aggregate Index by investing in a broad range on securities including investment grade and high yield bonds. It will be promoted by the firm's UK and European sales forces to institutional and retail investors in the UK and continental Europe.

The new total return European bond fund will be modelled on JPMAM’s existing series of relative value funds. These products which contain $3bn of assets under management target Libor plus 175 or 350 basis points with a value-at-risk of either 2 per cent or 4 per cent, respectively.

Educating institutions

The firm is also hoping to structure new types of collateralised debt obligation (CDO) products under the stewardship of Dominic Powell, who joined recently from Henderson Global Investors to head up the CDO product team.

But it is not enough to create so-called centres of excellence and launch new innovative products. Mr Donohue acknowledges the persistent need to educate institutional investors in the ways of porting and generating alpha.

He says: “While European pension funds are moving down the risk curve, they are not getting anywhere near the alpha they require. They are going to have to branch out into opportunities that they are not used to or understand that well. If you have a portfolio that is benchmarked against a UK or a gilt index we would ask the client to allow us to take off-index bets. That is how we are going to beat the index. Give us an allocation we can use at our discretion in mortgage-backed, high yield or European rates rather than just UK rates. We are trying to get more flexibility from our clients to allow us to take advantage of our centres of excellence. It takes time for them to get comfortable with that.”

Besides educating investors about the investment strategies on offer, Mr Donohue says the firm’s biggest challenge is to continue to find new opportunities for generating the excess returns promised by its new fixed income products.

“It is going to be tough to deliver the expected alpha given the current market environment of flat yield curves and tight spreads. Emerging market debt spreads are tight, credit spreads are tight. It will also be a challenge to avoid the inevitable dislocation in the market that is going to come.”

FIGURE TWO:  INTERNATIONAL  FIXED INCOME

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