USAA On Analyzing One Bond At A Time

Financial service giant coming into the ETF space with a tried-and-true approach to fixed-income research.

Reviewed by: Drew Voros
Edited by: Drew Voros

USAA, the financial services group that serves current and former members of the military and their families, is the latest large insurance/mutual fund company to enter the ETF pool. The company’s most recent filing suggests USAA will be modeling its exchange-traded funds after Vanguard’s approach to creating ETF shares out of its existing mutual funds. sat down with Matt Freund, chief investment officer of USAA mutual funds, and Paul Fulmer, AVP investment product management, to discuss USAA’s ETF plans as well as its fixed-income investing philosophy. Freund will be a speaker at’s Fixed Income conference Nov.4-5 in Newport Beach, California. What’s the investment philosophy or approach that makes USAA unique?

Matt Freund: One of the things that attracted me here was the philosophy that the investment team had the time—and still has to this day—of really focusing on the fundamentals. Sometimes we like to talk about these things as being old-fashioned. I would call them classic principles of investment management that are so timeless because they work over long periods of time.

We take a long-term view. We focus on fundamentals and valuation. We’re willing to be different from the crowd, to look different, even if it makes us look foolish in the short term. Are your mutual funds all active or are some of them index-based?

Paul Fulmer: We’re primarily active. We do run a couple of index funds as well. But I'd say our primary focus has been in the active space. From your filings, it seems you’re going to be modeling your ETFs after Vanguard’s patented approach to creating ETF share classes out of existing mutual funds.

Fulmer: We actually amended our exemptive relief letter a few months ago; in particular, to at least contemplate the potential to launch the funds as a share class or funds a la Vanguard. We’ve been in discussions with Vanguard in regard to licensing its patent for that structure. In your original filings, you list 14 of your current mutual funds that I assume would be the first ETF approaches.

Fulmer: We envision we’ll take many of our strategies that we're currently running in mutual fund structure and move them forward into the ETF space. That's not to say we won't look outside and create other strategies down the road that would come in an ETF form. But at least our initial focus will be strategies that we currently have employed in our mutual fund structure. Will the ETFs be cheaper than the mutual funds, as they are with Vanguard, generally speaking?

Fulmer: Yes. We haven't fully decided on the exact pricing, but our general thought is that our ETFs will be at or below our institutional share class pricing on the mutual fund side.

Freund: One of the things we strive for is to make sure we can deliver above-average service, above-average performance, for a below-average price. You’ll see that consistently across the platform, whether it’s the bond funds, the muni funds, the equity funds.

So the analogy to the Vanguard model is not quite exact, because we’re owned by a company that's owned by the shareholders. But the philosophy is right on. Let’s delve into your firm’s fixed-income approach.

Freund: We have a long legacy on the fixed-income side. We started as an insurance company, and insurance companies have a tradition of funding their liabilities with fixed-income investments. That's our legacy, and it goes back to the first days of USAA as an enterprise. That legacy has grown. We got into the mutual fund business in the early 1970s. But again, the longest and the most established teams we have here are on the fixed- income side.

We've been doing it for a long time. We've actually won the Lipper Award for the best large mutual fund shop twice in the last 10 years. We have a deep fixed-income team with traders, analysts and portfolio managers. And we have a long legacy of outperformance in that space.

Fulmer: From the ETF perspective, both because of our long-term strength and track record in the fixed-income area, we are contemplating going on to an active fixed-income ETF offering. We feel that fixed income is a good opportunity in the active ETF environment.

The other thing is, on our equity side, we want a mixed shop of both internally managed funds and strategies as well as a heavy use of subadvisors. So that's why we're kind of focusing on the fixed-income launches initially out of the gate. What was the final push that moved you into the ETF space?

Fulmer: We took a look at it from an industry perspective and clearly see the trend toward greater use of ETFs in the marketplace. We also took a close look at our membership base. We run a self-directed broker/dealer platform for our members. And we've clearly seen activity in ETFs pick up on that platform as well. We're in an environment now where people are constantly talking about interest rates rising. But they haven't. And this has been going on for years. How does whether the Fed raises rates now or later figure into your research?

Freund: The first thing to know about us is that we assemble portfolios from the bottom up. We buy them bond by bond, analyzing the risks associated with that security against the potential reward. Again, that sounds very old-fashioned, but that's what we do. We don't make big macro bets. I'm a huge fan of some of the big macro players out there. But we spend our time analyzing structures and securities, companies, different sectors of the market, while staying fairly neutral on a duration basis. We're not indexers by any means.

In fact, when you look through our portfolio, sometimes people say, “OK, who are you indexing to?” Just go back to the philosophy we talked about. We don't mind looking different. I think indexing in the fixed-income space is actually a fairly dangerous thing to do. You're buying securities because they have good underwriters, or because they just serially issue a lot of debt, or issue a lot of debt in terms of asset classes.

We don't do that. That's the first point. And we will vary our duration, but we'll move our durations within a fairly well-defined band. You generally will not see us much more than half a year from neutral on a duration basis.

That's how we approach the markets: very focused on individual securities, bond by bond, and really looking to make sure we're well paid for the risks we're taking on our investors' behalf. So are you saying all this noise around the Fed doesn’t impact your research?

Freund: I worry all the time. I wish I worried less. But in terms of the disciplined approach we take, we do the same thing every time, where we start with our research analysts. They're the tip of the spear. We have a talented trading desk, which is in touch with all of the major sell-side shops, looking for what is available and what sort of market intelligence is there. And then we have portfolio managers (PMs). A lot of our competitors were trying to get away with having PMs who did their own trading and then analysts who were really PMs. We've kept the traditional three-legged stool of the process.

To answer your question specifically, we’ve been pretty vocal for quite some time that rates were going to stay lower for longer. I think the first article I wrote on rates surprising people to the downside was in 2010.

This idea that rates are going to be going higher, and having to go higher right away, is the right diagnosis for the wrong disease. We have come through a balance-sheet recession. We got into trouble because there was too much debt.

There have been three major balance-sheet recessions in the last 100 years. One was the U.S. in the late 1800s; we had too much railroad debt. One was the U.S. in the '30s. The stock market had just corrected in '29. But the recession really lasted straight through the beginning of World War II. And then the last one is Japan, and that started 20 years ago and they're still kind of stuck.

The problem you get in balance-sheet recessions is that the traditional tools don't work. The recovery is generally very shallow, and pretty fragile; it's very on-again/off-again.

Again, this isn't my opinion; it's history. History shows that coming out of balance-sheet recessions, you have volatility in rates, and people are confused as to, again, what illness they're trying to cure. But ultimately that debt is very deflationary. And we've seen that around the world. Despite what we've done, we can't really get inflation going.

We've really been in an environment where the risk of rates spiking has been overblown. We've been taking advantage of that volatility to find nice securities out in the 20- and 30-year part of the curve.

But again, how you get your duration and where you keep your duration are two different things. So we're not afraid of adding bonds in that part of the curve, but our portfolios will have their durations more or less neutral.

Drew Voros has nearly 30 years' experience in financial journalism. He was a longtime business editor for the Oakland Tribune and sister papers of the Bay Area News Group, and finance writer for the Hollywood trade publication Variety. Voros' past roles have also included editor-in-chief at and ETF Report.