Q: What is the history of the fund?

The fund was established in March 2003, but has evolved since inception with the change in market conditions. We saw significant asset growth during the financial crisis, because the uncertainty in the marketplace prompted investors to look for the relative safety of a fund invested in securities guaranteed by the U.S. government. A Ginnie Mae fund certainly offers that characteristic. 

In the current environment, we have increased our focus on the liquidity of the fund’s underlying holdings. Securities and sectors that have previously met our threshold for acceptable risk/reward tolerance, may not meet the inclusion criteria today. 

Q: How would you describe your investment philosophy?

The fund is a pure Ginnie Mae fund, which focuses on government-guaranteed securities. We aim to provide consistency and value through a unique investment process that focuses on collaboration, transparency, and risk management.

While fund managers are required by mandate to invest a certain percentage of their assets in their universe, they typically have some leeway to invest a portion of the fund elsewhere. However, we believe that when shareholders choose to invest in a Ginnie Mae fund, they look for the safety associated with Ginnie Mae securities. 

If we deviate away from Ginnie Mae securities, the fund could disappoint clients. While some exposure outside the Ginnie Mae universe may add value in certain periods (for example, when markets are challenging and valuations are volatile), these exposures may cause a fund like ours to underperform and disappoint clients. So, we keep our focus on the core Ginnie Mae securities universe. 

We believe that we should treat our clients’ money as strategically and carefully as if it was our own. Our goal is to meet our clients’ expectations even during the most challenging times, or through extreme and volatile markets, and we have lived through extremely volatile markets. 

We believe in a highly collaborative team approach towards money management. We strive for consistent long-term performance over taking risks and searching for higher yields.

One key aspect of our approach is that our team manages both active and passive strategies, and we think that makes us better at both. I believe we bring a sophisticated, but real-world and practical approach to fund management and that leads to better outcomes. 

Q: What is your investment strategy and process?

This is an actively managed fund that aims to deliver consistent, repeatable performance that meets clients’ expectations. To accomplish this, we employ a disciplined investment process that seeks to generate excess returns above the fund’s benchmark, without assuming undue risk. 

The process begins with possessing detailed understanding of the fund’s benchmark and its associated securities and exposures, as it’s the benchmark we strive to beat. Following this, there are three key aspects of our investment process. 

First, we avoid large directional bets on changes in interest rates, such that the portfolio has duration that closely matches the duration of the benchmark. We are not trying to predict interest rates. 

Second, we seek to exploit inefficiencies or mispricing within the Ginnie Mae universe and relative to the fund’s benchmark. We believe that duration bets distract us from our focus on exploiting inefficiencies, and this is the most effective way to deliver long-term client value.

Third, we avoid exposure to non-Ginnie Mae securities, particularly to the various non-government guaranteed securitized products, such as asset-backed securities, commercial mortgaged-backed securities, or non-agency residential mortgage-backed securities. Often, Ginnie Mae fund managers have expertise in these subsectors. However, while these subsectors may at times offer value, we don’t believe they are consistent with the fund’s mandate. 

At Schwab, we believe that keeping our focus on Ginnie Mae securities and limiting duration differences relative to the fund’s benchmark is different and unique relative to the broader universe of Ginnie Mae funds. 

Q: What is your research process and how do you look for opportunities? 

Quantitative analysis is an important component of our research process, because it provides the ability to rigorously analyze large amounts of historical data. That’s particularly important when attempting to predict the behavior of individual mortgage borrowers and mortgage-backed securities. Often quantitative analysis can reveal opportunities that may not be as apparent with a more fundamental process. 

Nevertheless, we also employ a healthy degree of skepticism towards the model output. What makes our process solid is the combination of models, the understanding of their strengths and weaknesses, along with practical real-world judgment.

Q: Could you give us some examples that illustrate your process?

In the current low interest rate environment, which has continued for quite some time, most fixed-income securities are trading at premium dollar prices relative to par value. The implications for mortgage-backed securities are significant, because mortgage borrowers retain the right to refinance their mortgage at any time. While refinancing is often a good choice for homeowners, it’s usually detrimental to holders of mortgage-backed securities when prices are high. It is important to note that in an environment of premium prices, this refinancing activity erodes the premium dollar price associate with an above-market coupon. 

For us, one of the ways to add value is by understanding, anticipating, and purchasing securities with smaller sensitivity to changes in interest rates, or securities which are less likely to prepay than the market. We spend a lot of time analyzing borrower behavior, as well as that of the index. 

For example, now the fund has an exposure to borrowers that took their mortgages several years ago. These types of loans are backed by borrowers considered “seasoned”. While lower mortgage rates have been available to many of these borrowers, many have not exercised their option to refinance their mortgage. When borrowers have been able to refinance, but haven’t done so, that’s suggestive of their future behavior. These types of borrowers have demonstrated a slower prepayment rate relative to the current market, so our principal has eroded more slowly than the market. The focus on seasoned borrowers and seasoned loans has enabled us to realize small, but meaningful excess returns relative to the fund’s benchmark. 

Q: What is your portfolio construction process?

First, we have to understand and know well the benchmark and its exposures. The fund’s benchmark is the Barclays Ginnie Mae Index, which covers the mortgage-backed securities of the government National Mortgage Association Index. The name Ginnie Mae stands for Government National Mortgage Association. I would like to emphasize that Ginnie Mae securities are explicitly backed by the full faith and credit of the U.S. government. 

The Index includes Ginnie Mae securities backed by fixed-rate mortgages with original terms to maturity of 30 or 15 years. It is a fairly large index, with a market value of about $1.5 trillion dollars. 

The portfolio is typically constructed with small over- and underweights relative to the benchmark and its securities and exposures. Duration is typically closely aligned with the duration of the benchmark.

When constructing the portfolio, the availability of specific securities in the current markets is an important consideration. Given the size of the market, there is a large amount of available securities, but we also consider what other buyers may be doing. 

For example, in the current environment, the Federal Reserve is the largest buyer of mortgages, and that’s a key component in the consideration of availability. The Fed is engaged in quantitative easing and purchases securities to provide stimulus to the economy. Although it has ceased additional purchases to grow the size of its balance sheet, it continues to maintain the size of the balance sheet by reinvesting scheduled mortgage principal payments and prepayments back into the mortgage market. 

We track the changes in the index and its rebalancing. We spend a lot of time considering transaction and implementation costs. I believe our experience as both passive and active managers is an important asset in that respect.

On the passive side, when tracking the index, transaction costs are very important, because we are not really trying to beat an index. Trading only adds costs to a fund, so we are very sensitive to transaction costs. We bring this same level of diligence and detail to our active strategies. We may have a great investment idea, but if it’s going to be expensive to implement, we may pause and consider a different way to implement that idea. 

Another key aspect of the portfolio construction process is cash flow, both from client subscriptions and redemptions, as well as bond interest payments, prepayments, and scheduled maturities. We consider all those factors in our process.

The index typically reflects mortgages originated in the current environment. If a borrower took a mortgage in 2005 at 6% or 7%, he or she would have had several opportunities to refinance at a lower-rate mortgage and to save money on the monthly payment. In many cases, borrowers do exercise that option, and over time the coupon composition of the index drifts downs as mortgage rates go down. 

The current environment is backed by mortgage with lower rates, 3%, 3.5%, or 4%. Approximately 75% to 80% of the Ginnie Mae Index is backed by mortgages with coupons of 4.5% or lower. We own a good portion of the fund in those types of instruments, but we also focus on some of the borrowers with older mortgages, who have not exhibited a propensity to refinance despite multiple opportunities to do so. 

Q: Do you have limits on your provision sizes? What is the approximate number of securities in the portfolio? 

We hold a large number of securities, but we don’t necessarily focus on the number, because the aggregate level statistics and exposures are a bigger focus for us. The average position size is a function of the benchmark exposure to a particular security or a group of securities.

In terms of diversification, we try to have multiple active positions that add small amounts of excess return to the fund. We believe that concentrated investment exposures are not consistent with the broader approach that we take. Of course, there is a certain level of concentration as this is a Ginnie Mae fund, but we try to have as many different positions and exposures as possible, so no single position is responsible for an inappropriately large percentage of the fund.

The securities we hold are mainly backed by single-family mortgages. There are Ginnie Mae multi-family securities on the marketplace but they are not part of the index. We may have owned such securities in the past, but not today. 

Geographically, the securities represent most of the states in the country, and we consider the geographic factor when selecting individual securities. Certain geographies have a propensity to prepay more quickly or more slowly, and we would certainly consider that. 

Q: How do you define and manage risk?

One of the most important characteristics of all strategies managed by Charles Schwab Investment Management is that we have a truly client-centric focus on everything we do. We consider risk from a client perspective. We strive to ensure that all our funds, including the GNMA fund are designed to meet clients’ expectations.

A key component of managing risk includes introducing other parts of our business to the risk management function. That includes our product management team, the strategy and development team, the legal team, and the compliance team. Risk management is conducted in partnership with the investment team and the firm’s senior leadership. 

Since an important aspect of the fund is to remain true to style at all times, we make extra effort to ensure that the fund’s stated prospectus investment objective and our internal guidelines are consistent with what we tell clients.

Any fixed-income portfolio carries many different types of risks, and we constantly strive to understand and manage these. One example is model risk and we have a dedicated expert on our risk management team responsible for understanding models and the associated strengths and weaknesses of model outputs. 

We conduct various scenarios and stress tests to evaluate the types of outcomes and portfolio returns in different environments. So, we may shock the portfolio in a way similar to the Taper Tantrum in 2013 when interest rates rose sharply, or the financial crisis of 2008, or even back to the 2002–2004 period, when rates were falling back then and then sharply rose. It is important to know how our current portfolio would behave in different scenarios and what type of returns we would earn for the clients.

The overall goal of the process is to construct and manage a high-quality diversified portfolio that generates above-benchmark returns over short and longer horizons.