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 But figuring out what the managers of these "go anywhere funds" are
doing can give investors whiplash: managers are allowed to buy
whatever securities they want whenever they want, and have carte
blanche to do such things as sell Treasury bonds short and stuff
their portfolios with derivatives.
On top of that, the average unconstrained bond fund has 198 percent
annual turnover, according to Lipper, meaning that the securities in
the funds in March could have been completely swapped out by
September.
Understanding the mechanics of these funds has gotten so difficult
that even analysts at fund research shops Morningstar and Lipper
can't get a handle on what these portfolios are doing, analysts told
Reuters.
"A lot of promises have been made about unconstrained fixed- income
approaches and those promises have been a lot more powerful than the
level of disclosure that the funds provide," said Michael Herbst, an
analyst at Chicago-based Morningstar.
Fund companies say that the whole reason investors choose their
funds is because they don’t want to be bothered with the nuances of
what the managers are doing.
"When you switch over to an unconstrained portfolio mandate you are
lowering your interest rate risk, but taking on manager risk," said
Anne Walsh, assistant chief investment officer for fixed income at
Guggenheim Investments and co-manager of the $3.6 billion Guggenheim
Macro Opportunities Fund.
DURATION BETS
If the past few months are an indication, investors are right to be
concerned. Nine of the 10 largest unconstrained bond funds
underperformed the Barclays Aggregate Bond Index in the 12 months
ending June 30, as managers bet wrong by positioning their
portfolios for the Fed to raise rates last year, according to Lipper.
Unlike most "core" or intermediate-term bond portfolios,
unconstrained bond funds can have long, short or negative duration.
Duration is a measure of a bond's sensitivity to interest rate
fluctuations, and going shorter or negative duration is an
investment strategy pursued when rates are expected to rise.
A negative duration bond strategy can give investors a way to profit
from rising rates and lower bond prices by taking a "short" bond
position through Treasuries and/or Eurodollar futures. Conversely, a
negative-duration portfolio could underperform or even suffer losses
if rates fall.
And if the Fed doesn't raise rates, investors in funds including the
Pimco Unconstrained Bond Fund, which had a negative duration of 0.68
years as of July 31, and the Putnam Diversified Income Fund, which
had a negative duration of 1.54 years as of July 31, will likely be
disappointed if bond prices rise.
A Putnam spokeswoman wrote in an e-mail that the company believes
its Diversified Income Fund is well positioned for investors, given
that traditional multi-sector bond funds expose investors to
interest rate risk, while often underusing other areas of fixed
income such as credit risk, prepayment risk and liquidity risk.
"There has been much frustration by investors relative to core bond
funds because these unconstrained funds have been positioned for
rising interest rates and we have only seen Treasuries rally," said
Marc Seidner, chief investment officer for non-traditional
strategies and lead portfolio manager of the $7.9 billion Pimco
Unconstrained Bond Fund.
As an example, the $20.4 billion Goldman Sachs Strategic Income Fund
performed well during the "Taper Tantrum" of the summer of 2013, as
it shorted Treasuries, thus having negative duration, and delivered
a positive return of 1.47 percent. By year end, the fund's total
return was 6.43 percent.
The Goldman portfolio had a negative duration of 5.3 years at the
end of July 2014. However, that same negative duration turned out to
be a two-edged sword: In 2014, the fund was down 0.50 percent, a
year that saw the 10-year Treasury yield fall from 3.029 on December
31, 2013, to 2.172 on December 31, 2014.
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"It is not a timing product," said Michael Swell, portfolio manager
of the Goldman Sachs Strategic Income Fund. "We aren't going to get
it right all the time but our investment strategy is more right than
wrong."
As of June 30, the Goldman Sachs Strategic Income Fund had a
positive duration of two years. As of the end of last month, Goldman
Strategic Income's duration was 0.75 years.
While many of these funds' duration can swing wildly from one month
to the next, not all of them disclose their holdings and their
portfolios' duration monthly.
Only 50 percent of funds in Morningstar's "non-traditional bond
fund" category, which includes unconstrained bond funds, reported
their duration to the company every month.
For example, the Virtus Strategic Income Fund discloses its duration
and holdings quarterly.
FOGGY AREA
One example of how difficult it is to discern what is going on with
these funds is with the $994 million Western Asset Total Return Bond
Unconstrained Bond Fund, which held about 17 percent cash as of June
30, according to the firm. But until Reuters pointed it out,
Morningstar's data showed the fund had over 66 percent cash. Lipper
showed that the fund held 90 percent in cash, but the company noted
the fund was negative 75 percent in the "other" category.
The Western fund, which like many unconstrained bond funds uses
future contracts and other derivatives widely, was not including the
notional value of these contracts when determining the entire value
of the portfolio, while Morningstar was including the negative
exposure posed by these contracts, accounting for the discrepancy,
said John Martin, a portfolio data specialist at Morningstar.
The problem is that every fund company discloses and values its
derivatives differently, he said. "It's a foggy area," Martin said.
Western said it works with Morningstar and other data providers to
make sure that the characteristics of its funds are accurately
represented.
Morningstar changed the cash number for the Western Fund to 16
percent after Reuters discovered the discrepancy.
The U.S. Securities and Exchange Commission is working on a rule to
standardize disclosure of how funds use derivatives.
Given the lack of transparency and the latitude that managers of
these funds have, some advisers, like Josh Brown, chief executive
officer of Ritholtz Wealth Management, are telling their clients to
steer clear of these funds.
"Some of these funds will do well, and some won't," he said. "Based
on the limited amount of knowledge about what they are doing, how
can I possibly represent to my clients that I know which one is
going to work?"
(Reporting By Jessica Toonkel and Jennifer Ablan; Editing by John
Pickering)
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