Mary Ellen Stanek, Barron's article: In It for the Duration

Baird Core Plus Bond manager Mary Ellen Stanek isn't interested in making interest-rate bets or goosing returns with complex securities. She and her team are winning the "game of inches" the old-fashioned way, with credit work and common sense.

Mary Ellen Stanek, president of Baird Funds in Milwaukee, has been worrying about the value of a dollar for most of her adult life. In high school and college, she spent her summers working in a community bank, where her father was president. "I did everything from the night deposits to the switchboard," says Stanek, 56.

After graduating magna cum laude from Marquette University in 1978, she flirted with going to law school. But banking was in her blood. Rather than follow her father to the commercial side, she took an entry-level investment position at First Wisconsin Trust Milwaukee, where she was handed the task of researching the real-world implications of duration, an obscure concept at the time that is now paramount to any discussion of interest-rate risk. "Up until then, people used maturity to describe a bond's risk level," says Stanek.

For those of you who don't run a bond fund: Duration is a measure of how sensitive a bond's price is to any change in interest rates. Like maturity, duration is expressed in years. But while maturity is the time left before a bond comes due, duration incorporates the timing of any interest and principal payments prior to maturity.

Most people find it hard to gin up any interest in duration, let alone cultivate a passion for it, but it was at Stanek's first job that she found like-minded colleagues and began a 30-year partnership with Gary Elfe and Charlie Groeschell. "We've grown up together in the business world," says Stanek. In 2000 the trio left their longtime employer—which, after a name change and an acquisition, is now a division of U.S. Bancorp—and headed over to R.W. Baird, located in the same building.

Today Stanek is president of Baird Funds and, along with Elfe and Groeschell, oversees a 28-person fixed-income team and $16.7 billion in separate accounts and five bond mutual funds, notably the $1.9 billion Baird Core Plus Bond Fund (ticker: BCOSX). The fund has averaged a 6.9% annual return over the past decade, better than 92% of its intermediate-bond peers, according to Morningstar. Its 2.82% yield to maturity was recently 65 basis points (one basis point is 0.01%) better than that of its benchmark, Barclays Capital U.S. Universal Index.

While Stanek learned early in her career that duration is a key factor in interest-rate risk, the hallmark of the team's investment approach has been to neutralize it. Rather than try to predict which way interest rates will go, they match the duration of their portfolios with an appropriate benchmark. In the case of Core Plus, they adjust the portfolio every day to account for new cash flows and make sure the portfolio's duration is in line with the Barclay's Index.

Mary Ellen Stanek

That strategy isn't uncommon at smaller firms that don't make big macro bets. It can, however, mean that managers have less leeway to quickly adapt to rising interest rates, since they're not in the business of forecasting them. That's why tossing out duration decisions "removes one of the major levers for adding returns, particularly in a volatile environment," says Rick Beard, managing director of Cardinal Investment Advisors, who recommends Baird's fixed-income strategy to his institutional clients. Beard concedes, though, that "it's really hard to out-predict the market."

Moreover, "when you're trying to make interest-rate calls, you have to take your eyes off the other balls," Stanek says, adding she'd rather add value by focusing on yield-curve position, sector allocation, and security selection.

Fees are also a focus: Transaction fees, "the enemies of clients' wealth," says Stanek, are kept to a minimum. And at 0.55% (0.30% for institutional shares), the fund's expense ratio is nearly half that of its peers.

The team builds the framework of the portfolio based on where they want to be on the yield curve—currently the fund is over-weighted in seven- to 10-year bonds and underweight shorter-term government securities—and what sectors offer the best risk-reward. After that, the bulk of the work goes into individual security selection.

The fund often deviates from its benchmark, sometimes substantially. Today, for instance, financials represent 22% of the portfolio, but just 9% of the benchmark on a duration-weighted basis, which reflects the actual price sensitivity of the sector to interest-rate changes. While a black cloud still hangs over the sector—yields are about 225 basis points higher than comparable Treasuries—Stanek and her team have a different take: Not only are banks driven to keep their credit ratings high, she says, more-stringent regulations bode well for bondholders. "We wouldn't want to be shareholders in many of those companies," she says. "But we feel our bond positions have only been enhanced." They view bad news about financials as buying opportunities.

Clearly, the fund will take sector bets, but Stanek is careful to diversify its credit risk. Of the fund's 585 securities, its largest credit holding, General Electric (GE), accounts for just 0.99% of the portfolio.

Another area where Stanek and her team are comfortable straying from the benchmark is commercial mortgage-backed securities, which represent 7% of the fund versus 1% of the index, after accounting for duration. The group was beaten up by the financial crisis, but there are plenty of high-quality issues in the mix that offer higher yield without commensurate risk. Most of those are in senior positions underwritten prior to 2006, before underwriting standards began to deteriorate, Stanek says.
Stanek's focus on individual securities and the details of their often complicated structures help her win what she calls "a game of inches."

Baird Core Plus Fund (BCOSX)

	Total Returns*
	1-Yr	3-Yr	5-Yr
BCOSX	6.25%	9.13%	7.56%
Barclays U.S. Universal TR	5.04%	6.94%	6.65%

	% Of	Benchmark
Sector Breakdown*	Portfolio*
U.S. Treasury	25%	36%
U.S. Govt Agency	1%	3%
Other Govt Related	6%	11%
Industrials	16%	21%
Utility	10%	5%
Finance	22%	9%
Mgt Backed Securities	11%	14%
Asset-Backed	2%	0%
Com Mortgage Backed	7%	1%
Cash	0%	0%
*Duration-weighted composition All returns are as of Aug. 16, 2012
Sources: Morningstar

Core Plus is the most aggressive expression of Baird's very conservative fixed-income strategy. Though the fund isn't limited to cash markets—in other words, the buying and selling of actual bonds—it tends to stay away from those other options, such as derivatives, convertibles, non-dollar denominated securities, and anything else that many bond-fund managers use to goose returns.

"Some advisors have told us we're core plus 'lite,'" she says. But Stanek prefers to describe it as a "what you see is what you get" style of management that's focused on besting the index, but not at the expense of predictable returns. "Isn't that why people invest in bonds in the first place?"