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5 Things Your Fund Company Won't Tell You About Non-Traditional-Bond Funds

Sins of omission are still sins.

Eric Jacobson, 07/03/2014

Some non-traditional-bond 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 multidecade 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 characterized the bond fund environment up until the mid-1990s. The cult of stock-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 1994, 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 (does anyone remember the names Piper Jaffray Institutional Government Income and Worth Bruntjen?), 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 CDs 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 mutual 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 U.S. 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.

Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.

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