Tue, 31 Jan 2012
Morningstar director of fixed-income research Eric Jacobson dives into some of Morningstar's favorite flexible core bond funds and why investors should consider tapping active bond managers in today's environment.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
Amid a challenging environment for fixed-income investors, one strategy we've been advocating is to make sure that you have a flexible go-anywhere fund in your toolkit.
Here with me to discuss such a strategy is Eric Jacobson. He is director of fixed-income research with Morningstar.
Eric, thank you so much for joining me.
Eric Jacobson: Glad to be with you, Christine.
Benz: Eric, I'd like to drill into this strategy a little bit. I think it's easy to say, make sure you have a flexible fund on your side, but let's back up a little bit and talk about what about the current environment to you makes it so valuable to make sure that you have a truly active bond manager working on your behalf?
Jacobson: Well, the fact of the matter is, we're in a place where it's extremely difficult to figure out what's going to happen in the financial markets, much less the bond markets alone. Last year a lot of the smartest managers got sort of faked out by what was happening in the bond market, and even though most of them did reasonably well on an absolute basis, especially when you compare to how a lot of equity funds turned out, they couldn't match the indexes because they were being a little too cautious for the most part.
But that said, it's still important, I think, to turn over a lot of that decision-making power to a manager who's trying to keep his or her fingers on the pulse of what's going on, rather than trying to make big shifts in your own asset allocation.
We saw cases where folks chased the latest hot trends, and as an example, last year, did even worse, because they pulled their money out of their core bond funds that were still relatively anchored to the center of the fixed-income market, and didn't wind up getting even though as modest returns relative to the benchmark.
Benz: So, either they went really short, perhaps, or maybe they went into that new unconstrained bond category that we've got, and that's what you're saying, they didn't fare as well as they would have if they had just hunkered down with the core intermediate-term bond fund that we often recommend?
Jacobson: That's exactly right. Taking too much credit risk or taking off too much interest rate risk last year in 2011 caused a lot of problems for people.
Benz: Okay. So, now I would like to dig into some of these funds that you've long said are your favorites, and I think we all kind of throw them out there as very good, core, flexible options.
Let's start with the big name in the room; that's PIMCO Total Return. Also Harbor Bond, which is a near clone of the big PIMCO fund. Bill Gross-run funds. They've certainly got a lot of smart minds working on investors' behalf. Let's talk about not so much what you like about it--you obviously do--but what specifically do you think is the differentiator? When people are thinking about adding this fund to their portfolio, what do they need to know about its strategy?
Jacobson: Well, a couple of things. Even though the fund does take on risks that are often highlighted in the financial press--so, for example, when Bill Gross is pretty strong on interest rates one way or the other and talking about it--there is still an anchoring of that portfolio back to the benchmark. Even though he deviated from it quite a bit last year, as an example, he still managed to eke out a pretty reasonable return, even though, like I said, he was in the bottom of the category.
And at the same time, you're getting both a fund that keeps you relatively close to the center of the market, but also brings to bear tremendous resources, and frankly, the excellent record of success that Bill Gross brings in managing large pools of cash, and managing across sectors, and managing across the globe.
So, what you're getting there is a little bit of the extra spice that you want to pick up outside of the benchmark. You're not taking on too much risk, but you're still getting a world-class manager and a world-class team of people behind him.
Benz: So, you mentioned large pool of assets, and I think that is something that a lot of investors might posit as a risk for PIMCO and how much it's swinging around in this total return strategy. Can you quickly assess what you perceive to be the risk of all those assets, or do you view it as a risk?
Jacobson: I guess there is a temptation on the part of a lot of people to worry that there is some existential risk as a result of that size. I tend to think that that's a little overplayed. I think to the degree that there is a risk from the size, it could be that at some point it gets harder and harder for Mr. Gross to differentiate the fund and to outperform. I don't think that's really what we've seen in the last year. I think we saw a failure of an investment theme, an investment decision, rather than a failure of size. But certainly it's theoretical that if the fund were to get too big, he'd have difficulty differentiating it from the rest of the market.
Thus far, I don't think that's been a problem. There are certain areas that would be more difficult for him to get into if he really wanted to than others. If he wanted to make a huge bet on corporates, for example, that would be way outside of the benchmark's weightings, that could be difficult for a fund of that size, especially given the liquidity constraints we have right now. But that has not been the case. That has not been the way that he has wanted to go.
So, it's something that we're still always keeping an eye on, and we're looking at, trying to pick apart and understand it, but at this point, I don't think it's a major risk that you're going to have underperformance as a result of the size. But it's always something that we're monitoring.
Benz: Okay. Now in terms of its flexibility, what should people know about how flexible it can be? So could it be, say, a 100% corporates? How much leeway do they give Bill Gross by prospectus?
Jacobson: Well, that's very unlikely, because he is really anchored to the benchmark. And though he has at times taken, for example, duration relatively short, even last year when he went very short relative to the benchmark, it wasn't down to zero, which you saw in these non-traditional funds that you and I have talked about before.
With sectors, you're not likely to see variations in anything that's going to be extremely risky. You're not going to see it go to a 100% corporate or something like that. You may see, for example, outsize weightings in mortgages that we've seen before, but partly because that's the largest most liquid part of the universe. The bottom line is, he is very, very cognizant of that. He has become more attentive to that over the last few years, understanding that people as much as they want outperformance, they don't want to take on unusual risks.
Now that said, I will point out, as I said before, that they have non-U.S. bonds. At this point they have in the neighborhood of 18% to 20% non-U.S. developed market bonds, although they hedge a lot of ... the currency risk out. They do take some currency risk, but only generally a few percentage points. They also have around 10% in emerging-markets exposure--most of that is relatively short, though, usually. And they can take on as much as 10% or more in high yield, but they haven't been doing that lately, either.
Benz: Okay. Now, Eric, I'd like to move on to the next one. Another fund that's always on your shortlist when we talk about these good core flexible funds is Metropolitan West Total Return Bond. Let's maybe talk about how it differs from PIMCO. What do you think are its notable differentiators?
Jacobson: Well, it's funny because one of the things that has been an advantage about that fund is the lineage that it brought in the sense that its managers actually trained and came from PIMCO, and there are actually a lot of things about the fund that are similar to the way that PIMCO operates, but mostly just in terms of things like having a good, big, well-rounded-out staff of sector specialists, and so forth.
What differentiates it most in today's world is that it's not nearly as big, and so whereas PIMCO Total Return really has to rely, vast majority of its outperformance has to come from sector allocations, you get a little bit more availability with funds like Metropolitan West Total Return for the bottom-up individual bond selections to have a bigger impact on performance.
The other thing that you'll see if you look at the way the funds have been positioned in the last year or so is that Metropolitan West has been a lot more comfortable holding non-agency mortgage-backed securities, and that's an area that didn't work out particularly well last year, but it's one where they still have a very, very strong conviction that there is a tremendous amount of value still left in that sector following the financial crisis. It's not an area you're going to find PIMCO going into in a large way in PIMCO Total Return, in part because it's not the kind of big liquid sector that plays to Gross' strength, and in part because I think he doesn't believe that that's the appropriate place in his mind, where his clients want to be. But it's an area that we think has a potential to help the Metropolitan West Fund outperform over a longer period of time.
Benz: Okay. Now, if I'm comparing the two funds' risk potentials, I know it's a complicated question, but would you say they are roughly equivalent, or how would you stack the two up?
Jacobson: You know, there are a lot of ways to measure risk, and people would and will certainly argue with me on this, I suspect. But I think that generally speaking you'd expect Metropolitan West to be a little bit riskier than PIMCO Total Return in terms of its sector choices and exposures.
Benz: Okay. Now, I want to move on to another fund that I know you and the team like an awful lot. That's Dodge & Cox Income. Let's first talk a little bit about its general profile, what people can expect from the fund, and then maybe take it back to the preceding two funds and talk about how it's different?
Jacobson: Well, you know, by and large, it tends to be a more cautious, less intrepid core bond fund. It has taken on some excess overweights in corporates over the last couple of years, which differentiates it a little bit, but by and large we're talking about a fund that perennially errs on the side of caution, both in terms of not using a lot of derivatives and complex securities, and also even keeping duration a little bit on the short side oftentimes. So, if you had to line the three of them up, that one is going to be the less risky option of the three.
Benz: Okay, and certainly it uses that valuation-conscious approach that Dodge & Cox uses on its equity funds as well.
Jacobson: Exactly. I think a lot of the best bond funds think in those terms, but it really applies here, as you're suggesting, I think, because of that lineage of Dodge & Cox, and the fact that it bleeds over into the fact that they really have a strong focus on the corporate part of the portfolio there.
Benz: Right, so, looking at some of these businesses across the capital structure. Well, Eric, thank you so much for taking a deeper dive into some of these funds that I know we throw out there as being very good core holdings. It's been instructive for me, and I very much appreciate it.
Jacobson: Glad to be with you, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.