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Mutual Fund Q&A: 
Seeking Relative Value
BMO Short-Term Income Fund
Management: Vincent S. Russo

Author: Manish Shah
Last Update: 11:33 AM ET February 13 2012

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When looking for steady returns in fixed income, investors can find out that they are still exposed to market losses and volatility. At the BMO Short-Term Income Fund, portfolio manager Vincent S. Russo and his team utilize a careful selection strategy with macro and micro criteria for their diversified portfolio of short term bonds.

Q:  What is the investment philosophy of the fund?

A : Our fund focuses on the U.S. dollar denominated fixed income obligations that offer better relative values compared to the general market. We value a diversified portfolio of fixed income securities to reduce our volatility of returns and minimize downside risks.

As our investment philosophy is based on maximizing total return, we utilize a macro-economic view in our selection of individual securities that meet our fundamental investment criteria. Our relative value approach to fixed income market is an important style and philosophy. It allows us the ability to rotate in and out of sectors of the fixed income market we find attractive.

Q:  What are some of the critical factors in your decision making process?

A :
The fund is essentially an all-cash bond fund that invests in short-term maturities ranging from zero to five years in overall duration. Generally speaking, it is a U.S. dollar denominated bond fund which currently does not utilize any credit derivatives or futures contracts.

Nevertheless, we may own companies that are domiciled outside of the United States as long as they offer dollar denominated securities. Typically, these companies will have at least some presence within the United States.

Being open to new ideas, we challenge each other a lot in our investment analysis while expressing views of the economic trends and data analysis, or when reviewing specific investment themes or securities.

However, when it comes to selecting a specific bond or a security we are guided by the relative value approach. In our view, relative value is not only the analysis of the spread or additional yield, but is that additional yield worth the additional risk we are taking. In fact, it is this trade-off that we analyze before deciding whether to take the exposure or avoid the selection.

Another factor of significant importance to us is the price we end up paying, and we watch very closely ongoing changes in spreads. We also use the credit default swaps marketplace and equity prices as barometers to the risk profile of credits that we may or may not own in the portfolio.

Furthermore, we spend a lot of time in understanding the dynamics in various industry sectors like energy, finance, or utilities. Our analyst group spends an inordinate amount of time evaluating sectors as well as drilling down further to individual names within them. Through this process derives superior credit selection.

Q:  How do you generate alpha?

A :
We generate alpha relative to our peer group in primarily four ways: through asset selection, yield curve exposure, opportunistic investment, and credit selection.

The first step for us is asset allocation. Based on our technical views of the marketplace, supply and demand, relative spread levels, and relative risk profiles, we are not hesitant to move between asset classes at any time. Thus, asset class allocation is one area where we generate a lot of alpha for our shareholders.

The second area where we strive to add value is in looking at the yield curve and, in particular, where we are taking risk on the term structure of interest rates. That generally means altering allocations on the yield curve in line with our view from an economic or a yield curve perspective.

Then, we seek opportunistic alpha in three different ways. Being a provider of liquidity to smaller issue bonds, we can buy bonds at more attractive valuations and in our view is mispriced in the marketplace. Also, from an opportunistic sense we strategically add story bonds or fallen angels. In addition to that, we look for some longer term type assets that the market is currently underappreciating, and the best example right now are floating rate bonds.

Lastly, we add alpha through our careful selection of specific bonds. To this end, our analytical team employs a rigorous research process to track both individual credit and sectors where these companies may be trading.

Q:  What is your research process?

A :
As mentioned earlier, we combine a bottom-up and top-down approach. While looking at the macro economic situation we also look at individual bonds and evaluate merits of investments.

As part of my ongoing dialogue with analysts, it is extremely important for me to have a deeper insight into the overall situation in each fixed income sector, as well as in the companies’ competitive position and its cash flow.

Then, we look from a technical and a risk-return perspective at the dynamics in each of those subsectors. Once we have identified subsectors, we track from a bottom-up perspective, and that is where the analysts lead. At that stage we like to understand where the relative return story is. While it is important to identify the negative factors driving the weak market segment for the security, we also want to gauge the upside and are there any catalysts in place.

We narrow down our bond selection to a group of core names that we watch while waiting for our price targets to hit. If we do find the attractive price point to enter a position, and as long as the fundamental case is still the same, we will add the bond to our portfolio.

We have all the technical skills and system tools at our disposal to analyze bonds across the fixed income universe and we use trading platforms and other tools that perform spread analysis. The toolkits that allow us to evaluate the spreads across sectors are equally important with tools that we use to generate alpha.

For example, the current worries in the global sovereign bond markets and the potential for one of the smaller countries in the euro zone to default on their debt obligation are quite high. Just as we did in 2011, we could experience significant volatility for a sustained period in the current year too. That is why, looking at the risk-return profile of the bonds relative to Treasuries, I think short duration corporate bonds make a lot of sense at this moment.

Q:  How did the Greek debt crisis affect your investment process?

A :
Our view was that Greece was ultimately going to restructure. Yet, we also viewed Greece as a relatively small economy and as an example of what ultimately happens in other sovereign nations that are heavily indebted in the euro zone.
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