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Short Duration with an Alternative Bent

Jason Stipp

K.C. Nelson is the manager of Driehaus Active Income and Driehaus Select Credit.

Stipp: I'd like to turn and discuss your fund, Driehaus Active Income. This is a fund that's covered by our alternatives analyst, Nadia Papagiannis. It's an interesting strategy. So, one of the things that she wrote about your strategy is that you aim to have a duration of zero, which from an inflation standpoint, or a rising rate standpoint, would seem to be a pretty safe bet against rising rates. But yet, we've also seen very low duration instruments have very, very little yield. You're not really getting paid a whole lot to be in those short-maturity investments. So how is your fund looking to make money and looking to make return with a duration that's at zero?

Nelson: Sure. I think the reason why there is a difference in return expectations between our strategies and the typical short duration bond fund is that most short duration strategies tend to focus on investment-grade instruments that are very short in terms of average maturity. That's not really what we do. We're a multi-strategy absolute return credit fund. We operate in multiple segments across the capital structure and in all types of products along the credit spectrum.

So we trade loans, bonds, convertibles, CDS, even equity options and equities for hedging purposes. So, we are quite different than your typical short duration fund, but across all of our strategies, we attempt to hedge our duration back to roughly zero. So, the edge, so to speak, that we're providing is being able to assess value across a company's capital structure as opposed to making the right call on interest rates. So, that's obviously been an attractive characteristic of our strategy over the last couple of years as investors attempt to bring duration down in their fixed-income portfolios.

Stipp: So, it sounds like you have a pretty wide-ranging stomping grounds where you're looking for opportunities. Are there any specific areas where you've been able to find especially attractive opportunities and have there been any areas where you just really haven't seen anything to invest in recently?

Nelson: Sure. So, I just finished our monthly commentary the other night and in it I wrote that we find low-quality high yield as one of the best places to invest right now and that's something you oftentimes don't hear a lot of people talk about. But we find quite a bit of opportunity right now in the CCC segment of corporate bonds.

Oftentimes those companies are yielding 10% to 12% to a five to seven-year maturity, and frankly their business models have withstood the shock of the credit crisis. They are very lean. They have pushed out their near term maturities, so very well prepared if we go through another financial shock, and frankly their business results haven't really varied that much whether real GDP is kind of growing at 3% or 1%. They have been muddling along just fine in a low-rate environment, where there is a lot of volatility in the equity markets. We think that's a pretty interesting place to invest.

On the less attractive side, I'd say a lot of investment grade credit products--you are looking at spreads near historical averages or tighter than historical averages. So, at this point, really you're just making a bet on rates. With the 10-year below 3%, that's not really a bet I'd advise people to make. And convertibles to us also seem fairly rich on the whole. So those have been two areas that we had been avoiding for the most part.

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Stipp: So you mentioned high yield there in the first part of your answer. I think most people tend to this is a riskier area of the market, so I wanted to talk to you a little bit broadly about risk and managing risk in your fund. You talked about how you're basically canceling out the interest rate risk with how you're managing the duration, but how do you manage risk? And you have managed risk, Nadia says, very well in your fund. What are controls you put there and how do you think about risk broadly?

Nelson: So, the number one objective across all of our strategies is, we manage our funds to a stated volatility target. So, before trying to capture return, we try to keep risk under control for our clients. So, in the Active Income fund, we aim to produce volatility similar to that of the Barclays Aggregate Bond Index, which over a market cycle could be characterized as roughly 3% to 5% a year.

In the Select Credit Fund, we aim to produce volatility similar to that of the high-yield index, which over a market cycle could be characterized as roughly 6% to 8% on an annualized basis.

How we do that is on a position-by-position basis, we look at a number of quantitative risk factors like, how much spread exposure do we have, how much rate exposure do we have, how have these trades performed during previous market sell-offs, how do they correlate to the rest of their fund?

On a qualitative basis, we spend some time thinking about who owns the securities we're involved in, is it a lot of long-only folks, is it a lot of levered hedge funds, how easy are they to price, do they trade every hour, every day, every week? Those types of factors.

So, in the past that's been a good formula for us in terms of containing volatility and both funds have actually been less volatile than their index historically. So, hopefully, we'll be able to continue to do that in the future.