Not least because of this active exchange-traded fund’s modest fee hurdle, Franklin Short Duration U.S. Government is an interesting mortgage-focused option within the short government Morningstar Category; but questions about its team and long-term strategic edge provide pause. 
To be sure, the record here over nearly 10 years is competitive. Since lead manager Patrick Klein’s late 2013 start, the fund’s 0.87% annualized gain through September 2023 eclipsed its mortgage-free Bloomberg U.S. 1-3 Year Government Index by 7 basis points and compared favorably to the small subset of category rivals that typically invest half or more of their portfolios in agency mortgage-backed securities, finishing third out of 16.
Flexibility exercised with restraint has helped the strategy achieve that record. Klein and comanagers Paul Varunok and Neil Dhruv, both securitized specialists, have varied the strategy’s mix of agency fixed- and adjustable-rate MBS, their TBA mortgage counterparts (very liquid, more generic, forward purchase contracts), agency debt, and Treasuries, while avoiding potentially volatile or illiquid securities like interest-only and inverse IO securities.
The strategy’s persistent bias toward muted interest-rate sensitivity has also often helped. Over the past five years, its average duration position has been about 1 to 1.5 years, versus 1.9 to 2.2 for the Morningstar Category median.
Questions start with team organization, though. Klein previously worked in the same group as Varunok and Dhruv, but that hasn’t been the case since mid-2016, and Klein’s time is now largely devoted to his duties as head of Franklin’s sizable multisector and quantitative strategies team, including helping to run nine other strategies. 
Most of this strategy’s investment picks come from Varunok and Dhruv, but they have become increasingly reliant on a mortgage prepayment machine learning model (a type of artificial intelligence) only implemented in 2021. Changes like a March 2023 model adjustment to enable it to better handle market regime shifts are still more recent, and the model’s multiyear efficacy remains to be seen.

Analyst Rating

Interesting, but questions remain.

Director

Alec Lucas

Lead manager Patrick Klein left Franklin’s securitized team in mid-2016 but still draws on it here, especially via his comanagers and members of that team, Paul Varunok and Neil Dhruv. It’s not clear the group’s efforts carry a competitive advantage, though, and the fund receives an Average Process rating. 
This strategy’s broader opportunity set leads to a different profile than its mortgage-free Bloomberg U.S. Government 1-3 Year Government Index. Whereas Treasuries dominate that bogy with a smaller slice of U.S. agency debt, AMBS dominate here, and the strategy can also invest in Treasury Inflation-Protected Securities. 
The macroeconomic outlook of Franklin’s larger fixed-income group informs the managers’ approach to positioning the portfolio’s average duration, which they cap at three years but often keep considerably shorter. Sector allocation and security selection largely comes from the securitized team.
Since a mortgage prepayment machine learning model (a type of artificial intelligence) became operational in 2021, the securitized team has increasingly integrated that model into its approach, such as optimizing which coupons to choose based on expected returns over a three-month horizon. Still, changes like a March 2023 model adjustment to enable it to better handle market regime shifts are recent, and the model’s multiyear efficacy remains to be seen.

Average

Process

Concerns about structure, increased duties, and the team’s ability to stand out earn the fund a People rating of Average.
Lead manager Patrick Klein has distinguished himself within the firm since his 2005 industry start at Franklin Templeton. The mechanical engineering Ph.D. then joined Roger Bayston’s team to apply his modeling skills to agency MBS. By late 2013, the firm named him on this strategy alongside Bayston. In mid-2016, however, Bayston’s team split into a securitized group led by Paul Varunok and a multisector and quantitative strategies team, with Klein joining the latter even though he relied on securitized input for this strategy. Another 2019 reorganization led to Bayston leaving this strategy and Varunok joining while Klein’s workload increased. Indeed, he now heads up the sizable multisector and quantitative strategies team and is a named manager on 10 distinct strategies.
The San Mateo-based Klein works closely with Varunok and Neil Dhruv, a veteran securitized specialist who became a named manager here in August 2021, but geography seems like a potential obstacle. Four members of Franklin’s 10-person securitized team reside in New York, five in India, and one in Singapore. 
Retaining analyst talent was also a challenge between 2018 and 2021, when the team lost four analysts. Four securitized members have joined since late 2020 to replace them, but that’s a relatively short stretch.

People

Franklin Templeton Investments, the asset-management arm of publicly traded but family managed Franklin Resources BEN, has been busy with acquisitions. The struggle in streamlining these disparate capabilities underpins its Average Parent rating. 
Franklin’s July 2020 acquisition of multiboutique manager Legg Mason remains its largest as of March 2023, but the firm has continued to grow through acquisitions. Its April 2022 and November 2022 purchases of Lexington Partners and Alcentra, respectively, make it one of world’s largest managers of alternative investments (with alts comprising USD 231 billion of its USD 1.4 trillion assets under management as of December 2022), while its July 2022 acquisition of O’Shaughnessy Asset Management adds a novel direct-indexing capability to its managed account offerings. These purchases, however, do little to alleviate the operational complexity of a firm with dozens of investment teams split by asset class, region, and investment platform.   
Although there are several standout strategies at the firm, many teams have struggled with personnel turnover, succession challenges, and unappealing performance patterns. Shepherding these geographically disparate capabilities, which have varying levels of centralization of distribution and risk management, shall be quite the challenge for the firm to manage.

Parent

Franklin Short Duration U.S. Government ETF

FTSD is an actively-managed ETF that aims for a targeted duration of less than three years by investing in short-term debt securities issued or guaranteed by the US-government. The fund manager may also invest in certain interest rate-related derivative transactions.

Rising interest rates are punitive for longer-dated bonds. Combine that with fixed income investors' fears about yield curve inversion, and it's not surprising that many market participants are gravitating to short-duration fare.

Aversion to Yield Curve Inversion? FTSD Could Be Fabulous

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The deficit spending that supported the economy in 2020 is showing up in hot inflation numbers in 2021. While I think the inflation numbers will get better in 2022, I do not believe they will get back to pre-pandemic levels because of owners' equivalent rents and wage gains in the CPI.

Mind The Bond Market

Inflation expectation is a key metric the Fed watches closely. Housing costs - based on different measures of rents - account for one-third of CPI.

Inflation Expectations Come Unanchored

News for Franklin Short Duration U.S. Government ETF ETF (FTSD)