5 Things to Understand About Unconstrained Bond Funds

Non-traditional bond funds such as flexible allocation and unconstrained funds aren't the cure-alls some fund companies are suggesting

Eric Jacobson 7 July, 2014 | 11:11AM

Some non-traditional bond funds, such as flexible allocation and unconstrained funds, are certainly a lot better than others, but as a broad group they aren't the cure-alls some fund companies are suggesting. Here are five things they probably didn't mention.

1) The idea behind these funds isn't as novel as it sounds.

There's a running industry narrative that non-traditional-bond funds have sprouted up as an organic response to the (obvious) end of a multi-decade bull bond market and that the idea of an unconstrained duration strategy is a unique response to this rare market condition.

The fact is, however, that the idea of managers having the freedom to shift their funds' durations sharply and to actively anticipate movements in interest rates is an old one that characterised the bond fund environment up until the mid-1990s. The cult of equity-fund investing was still in its early development, but the foundational idea of hiring a guy like Peter Lynch to invest your money virtually however he saw fit--and among whatever stocks, regardless of size or valuation--was somewhat in vogue among bond managers, too. They couldn't shift among bond market sectors in most cases, but they usually had a lot of freedom to manage interest-rate exposure, and many investors assumed that's what they were hiring them to do in the first place.

A number got a rude awakening when interest rates spiked in the 1990s, though, and some managers were caught badly off-guard. Why? Macroeconomic calls are really hard to make consistently. Some of the worst damage occurred among funds that had gorged themselves on very long-duration mortgage derivatives, but legions of investors who owned funds with smaller losses were still shocked. Huge numbers of them had been talked into fleeing the painfully low rates on their cash deposits by brokers breezily pitching the virtues of government-backed mortgages. And it didn’t help that some popular balanced funds had aggressively trafficked in emerging-markets debt that swooned in 1994, as well.

Within a few years' time, just about every bond-fund manager had adopted what had previously been considered institutional management best practices and in particular began benchmarking their portfolio durations in a modest range around an index. Even more telling, however, is that, until the rise of the unconstrained funds that dominate the non-traditional-bond category, almost every single manager's marketing pitch involved claims that nobody could consistently and successfully manage interest-rate bets of any size and that it was obviously folly to take bets big enough that they could threaten to dominate a portfolio's returns.

There are a lot of fund marketers out there today who either weren't in the business just a few short years ago or who have evidently suffered a miraculously collective touch of amnesia.

2) No, we don't have a lot of history with this strategy, but it probably wouldn't be that pretty if we did.

Although a handful of funds did pursue strategies consistent with the non-traditional-bond group before the category got hot, it's dominated by so-called unconstrained mandates that didn't invade the fund universe until the past few years. That means that only a very small handful of funds in the group were even around during the 2008 crisis, and that only about half the category was around during the third-quarter 2011 European crisis and attendant US Treasury bond flight to quality.

Meanwhile, some of those with longer records even had different names and mandates until their fund companies decided to jump on the unconstrained bandwagon. Without a more serious credit-market stress test--the 2011 stretch was short and relatively shallow in its severity--it's extremely difficult to know how vulnerable most of these funds might be in the event of a nasty downturn.

We have to take the results of the few funds that were already around in 2008 with a grain of salt given that most hadn't yet adopted strategies that involved avoiding interest-rate risk, but many of them did and still do have sector profiles with a lot of aggressive sector and credit exposures. If anything, having some Treasury bond sensitivity almost certainly helped most of them to perform better in 2008 than they would have if they had looked more like they do today. If their results from that period are any indication, though, the picture still isn't pretty. A few unconstrained bond funds eked out positive returns that year, but most suffered substantial losses. 

3) We're not going to talk about their risks unless you put our feet to the fire.

Much of the literature that fund companies produce is really just marketing material dressed up as white papers. In this case, many asset managers make it sound like everyone should flee any fixed-income investment that bears interest-rate sensitivity and entrust managers with the flexibility to invest heavily in just about any sector and with the task of anticipating and getting ahead of the next big market move.

That kind of freedom demands an even keener eye on risk. But while most managers use a variety of their own tools to gauge how much risk they're taking, most funds in this category use an absolute return "benchmark" keyed to short-term rates such as Libor (which usually tracks closely to those controlled by the Federal Reserve) that provides no template or parameters for risk control and no universe of securities to allow for meaningful apples-to-apples risk/reward comparisons to their funds.

Ultimately, the marketing pitch tends to coalesce around the idea that you can enjoy returns commensurate with what intermediate-term bond funds would otherwise produce, you can sidestep interest-rate sensitivity while doing so, and you can expect to avoid losses given that you'll be investing in an absolute return strategy. In short, a free lunch for everyone.

There are some very fine people who are in the business of making such pitches, but it's still pretty impressive that most of them can keep a straight face while offering up a suite of investing benefits that are, almost by definition, impossible to provide all in the same package. Ultimately, anything that sounds that good to be true should probably be making the hair on the back of your neck stand up.

4) These funds may taste great, but they're not less filling.

Why would it be so hard to deliver that kind of Shangri-La investment? Because it's practically a law of nature in investing that there's no reward without a commensurate risk. There are and have always been investing vehicles that look as though they can deliver such a thing, but just because their risks aren't easily observed doesn't mean that they don't exist. In fact, the more perfect an investment looks, the more worried you should be that there's a risk even bigger than you might imagine lurking under the covers.

What does that have to do with non-traditional-bond funds? Almost all of their marketing focuses on the fact that their interest-rate flexibility is designed to protect you from rising rates, but it doesn’t explain how they're going to make up the return difference that would otherwise result from doing nothing but stripping out a fund's rate sensitivity. Without capitalising on the basic fact that longer-dated--more rate sensitive--bonds almost always yield more than shorter-dated debt, the only way to keep up with an otherwise identical portfolio that does have interest-rate risk is to take on risk somewhere else.

What aren't they telling you? The average fund-marketing pitch isn't going to spend much if any time on how they're going to make up for the loss of return potential of a longer-duration portfolio. The information is there to see, if you even scratch the surface of a fund's portfolio statistics, and what you find may leave some investors feeling a little queasy. Morningstar's latest data show that the average fund has a whopping 40% exposure to investments rated below investment grade (or that don't have ratings). That compares with only 13.5% for the average intermediate-term bond fund, and there aren't any such exposures in the Barclays US Aggregate Bond Index.

Go back to the 2008 illustration and consider why funds around at that time performed so poorly and what they have in common with today's offerings. In effect, today's non-traditional-bond funds look an awful lot like 2008's multi-sector bond portfolios, complete with big below-investment-grade exposures and maybe some foreign developed- and emerging-markets debt for good measure. In fact, because of today's interest-rate fears, the one thing most non-traditional funds don't have is the very interest-rate sensitivity that would otherwise provide some insurance, in the form of exposure to rallying Treasuries and Gilts during a panic-induced flight to quality. Ironically, it was just that kind of exposure that kept most of 2008's multi-sector funds from losing even more than they did.

5) We couldn't be giddier about how much you're paying us for this.

You won't hear them say it out loud, but new categories of funds nearly always come with higher fees, and fund companies love to get clients to move to new, higher-cost funds run by the exact same people running their core portfolios. On an asset-weighted basis, the average pound invested in the institutional share classes of non-traditional-bond funds is paying nearly twice as much as those invested in intermediate-term bond funds. And that’s only how much the average pound invested in the category's institutional shares are paying; retail investors are almost universally getting a much shoddier deal.

Of course, you may hear that there's good reason for all of that because non-traditional-bond funds are really more like hedge funds than traditional core bond funds. And aside from the fact that these unconstrained bond funds come at a bargain price compared with what you'd otherwise have to pay for a hedge fund, you might get the impression that firms need to charge more in order to offer the expertise and operational resources required to run portfolios like these.

Not so fast. It's theoretically possible that, among some small shops with few managers and simpler operational systems, running a non-traditional fund could require capabilities that cost more. In practice, though, almost every large asset manager running funds in this group today already had all the resources they needed to get into the category. They've almost all been using scads of derivatives and complex, esoteric securities in their other portfolios, in many cases for years. Most of the time, the idea that they had to begin spending more money to cope with such things just doesn't wash.

And what about needing more, or different, managers to run these new strategies? In all but a few cases, and this includes smaller players, firms have done nothing more than add another strategy onto the plates of managers who were already toiling away with big, conventional bond funds. In fact, in most cases the argument is that they're really just taking better advantage of everything they've always done, only now with a freer hand.

In other words, many fund firms have found a terrific "product" that they can run with the same people and resources they already have in place and yet charge almost twice as much. Maybe the threat of rising rates isn't so bad for business after all.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Eric Jacobson  is director of fixed-income research with Morningstar.