Thu, 6 Oct 2011
Given these funds' wide latitude, investors should move slowly (if they move at all) into these offerings at this point, says Morningstar's Eric Jacobson.
Christine Benz: Hi. I'm Christine Benz for Morningstar.com.
So-called "unconstrained bond funds" have some of the fund world's biggest asset gatherers over the past year. Here to discuss what these funds are, how to evaluate them, and whether you need one is Eric Jacobson. He is director of fixed-income research for Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Good to be here. Thank you for having me.
Benz: So, Eric, it seems like in a really confusing fixed-income environment, a lot of investors have flocked to this unconstrained bond funds as sort of a way to span the waterfront in fixed income. What are these funds and what are they investing in?
Jacobson: Well, as you know, a lot of them were hatched in a time period leading up to this year, where there was a lot of fear about rising interest rates. So, really, what they are at the core, regardless of what a lot of the marketing material says, is, they are a way for fund companies generally to offer something that looks a little bit like a core, or multi-sector bond fund, but without much interest rate sensitivity. What I've just said sort of boils it down. You are not going to often hear that from certain companies depending on how they're trying to market them, but that's kind of what you are getting in a lot of cases.
There are different flavors, though. Some of them are much more like core bond funds. They've got a lot of different sectors in them, but they are using things to keep interest-rate sensitivity low. Others are a little bit more sector focused, despite the names and so forth. And that right now, for example, would describe this JPMorgan Strategic Income Opportunities Fund, which has been really popular. It has a lot of high-yield exposure in it.
But by and large, they are either, like I said, very little interest sensitivity, lots of ability to go anywhere, in terms of sectors...
Benz: So, global as well as, just U.S. focused?
Jacobson: Absolutely. And a lot of them also, because of what I just described, even though they were originally sort of conceived as unconstrained, a lot of them tend to overlap with what you might call "absolute return bond funds"--the idea being that they want to try and make money in almost any environment, a lot easier said than done.
Benz: Right. So, if I'm looking at one of these funds, trying to figure out what's in it, trying to figure out whether it's a fit for my portfolio, what are some of the key things that I should be checking up on?
Jacobson: Well, the first thing, I think, to think about is the fact that, these are still relatively new in the mutual fund format. We've tried to tell people, if you are looking for one, here are some teams that we like. But we're not out there pounding the table telling people to buy them, in part because, again, they're not that well tested in the mutual fund format. Even the data for how these funds existed in other formats hasn't been all that impressive always. But what you want to look for are the same things you want to look for in any kind of bond fund, which is the kind of team that has the capability to do the things that they say they're going to do.
So in other words, if there is going to be a lot of international exposure, there's going to be currency, there's going to be high-yield, there is going to be mortgages, there is going to be U.S. corporates. You hopefully want to see core competencies in those areas, and there aren't that many firms, frankly, that look really good across the board. You're going to hear a lot of firms tell you, "Oh, we're a big, big firm. We manage hundreds of millions of dollars. We have been doing this for years, so we really know this stuff," but the fact is that in some cases you are talking about one or two people on a team rather than perhaps a whole entire business built around it. So you've got to be selective.
Benz: So you want to look at other funds that the family runs within those sleeve areas and see how they’ve done there?
Jacobson: That’s right, and that’s, unfortunately, not even going to tell you that they’re going to be great at it, because not only do you have to get a lot of that stuff right in order to do this well, you’ve got to get the big macro calls right.
Benz: The allocations among the various components.
Jacobson: Exactly. You've got to do well on those sectors, you’ve got to do the allocations well, and by the way, now especially if you are doing interest rate positioning and/or currency, it’s a lot more to get right.
Benz: We haven’t seen that many funds that have done that overall quarterbacking where they have been allocating resources to different components, as you say.
Jacobson: That’s right. There are a handful that have some experience with it. The big names people know: BlackRock, PIMCO etc., but there aren’t that many.
Benz: So if I am looking at a fund like this, how should I use it? Should I use it alongside other core bond positions? Is it meant to supplant my core bond positions? I guess you are going to say it depends on what’s in the fund.
Jacobson: It does depend on what’s in the fund, but I will say I think it’s fair to generalize that I think most people were hoping and are hoping that they can buy one of these to supplant their core fund, especially they who were very worried about interest rates rising as of last year, early this year; they wanted to see it as a substitute for a core fund. And the fact of the matter is that they may not be the right choice. My best suggestion would be, if you are intent on owning one of these, start it off as an add-on holding or a supplementary holding, see how it works in times of stress and so forth. We're just now starting to get a feel for how some of these act when the chips are down, which is kind of what happened in the last couple of months in the bond market, because a lot of them didn’t really exist in their most standard forms up until just prior to the financial crisis of ’08.
Benz: It sounds like generally speaking, though, they are not going to hold a lot of Treasury bonds, say, or high-quality corporates that would populate my other core bond positions?
Jacobson: It's correct in the sense that that’s not where they have gone. It would be possible to construct a portfolio like that and squeeze out a lot of the interest rate volatility, but the reason that they haven’t lately is that yields on Treasuries are so low and even on high-quality corporates, they are not generous enough to really make up for that yield hit. What they really want to do is, they want to have their cake and eat it, too. They want to have no interest rate volatility, but they want to deliver lots of income and a decent return. And in order to do that, you’ve got to not hold a lot of Treasuries. You’ve got to hold some more volatile things, but then you’ve got to hedge out the risk either by holding a lot of cash or using derivatives of some kind create shorts in there.
Benz: So it sounds like because the category is so untested, you don’t think it’s a screaming buy, but I am wondering if you can discuss some of the funds that you think, right now, appear to be the most compelling within this relatively untested group.
Jacobson: Let me reframe it as... let’s discuss some of the funds that have been really popular, too, because I think people probably want to hear about them either way. The one that I’ve considered most compelling just from a resource perspective has been this PIMCO offering, PIMCO Unconstrained, but they’ve had a rough time of it this year, as has PIMCO in general with some of their core funds. So you can’t look at that fund and say, "Oh, it’s doing exactly what everybody wanted it to."
The JPMorgan Strategic Income Opportunities Fund, which had been a leader in terms of bringing in assets--I understand that they've had some outflows, and more than anything, that fund is a lot of cash and also a lot of high-yield exposure.
Now the manager, Bill Eigen, will tell you there is a lot more going on in that fund, which there is. He's got some long/short plays and some relative value bets and so forth, but the fact of matter is, the performance has been dominated by high-yield.
Now the good news is, it hasn't lost as much necessarily in all cases as the high-yield market when the high-yield market itself has gone down, but it has been highly correlated to the high-yield market. So it hasn't had the ups and downs to the magnitude of the high-yield market, but it has moved with it quite a bit. So I think shareholders there are probably ... luckily, he was out front explaining these things beforehand. Even a couple of months ago, I remember him saying, people need to brace themselves because there is going to be a lot of volatility. He was predicting it. He didn't get out of the way. Now I think that was because he felt there was a lot of value in a lot of the high-yield securities that he held, and I think he's the kind of guy that would probably say, "Hey, if you liked it at that price, you’re going to love it at this price," because high-yield sold off a lot.
Benz: So, Eric, it sounds like you’re saying, go slowly if you go at all, and also know what you own and do some investigative research before you buy one of these funds.
Jacobson: Absolutely. I mean, it’s kind of a broken record with me to say those things, but it’s especially important with bond funds, and it’s especially important with bond funds that have the kind of flexibility that these unconstrained funds have, because there aren't a lot of guardrails on the side. They can do a lot. If they are not well run, they can create a lot of trouble for you, too.
Benz: Especially if you’re using such a fund as ballast for your equity portfolio.
Benz: Well, thanks, Eric, so much for sharing your insights. We always appreciate it.
Jacobson: My pleasure.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.