Thu, 27 Sep 2012
And not in the good way, as Morningstar's Eric Jacobson cautions that numerous portfolios in the category have proved to be more volatile and have lower returns than some might think.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. So-called nontraditional bond funds have been major asset gatherers during the past few years. Joining me to provide an update on this category is Eric Jacobson. He is a senior fund analyst with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Hi, Christine, great to be with you.
Benz: Eric, nontraditional bond is our category for this grouping of funds, but there really are some different strategies going on. Let's talk about the unifying themes among these nontraditional bond funds.
Jacobson: Sure. Well, the unifying themes tend to be a question of interest-rate sensitivity for the most part. They didn't all start out that way, but that's kind of how they've coalesced. And for the most part that means that they generally have a very wide range within which they can manage their rate sensitivity. They generally define it by duration, and they often can go a little bit negative and very long to the positive. That gives them a tremendous range, as I just said, to go in. But a lot of them have been managing themselves very close to the short end of the range. Arguably [they do this] for tactical reasons. So the trick there is we don't really know how many of them might actually go a lot longer at some point because they say they have the freedom to do it. But, like I said, most of them have stayed pretty short.
Benz: Part of the value proposition, Eric, right now in particular, if people are concerned about rising interest rates down the line, the idea with some of these funds is that they might be able to navigate a little better than funds that are pegged to, say, a specific duration range?
Jacobson: That's right. They didn't all market themselves quite that way to start off with. But that is the unifying theme and the unifying marketing message frankly, at this point. They're all trying to convince investors that they're the best place to be pretty much if you fear rising interest rates.
Benz: Eric, are these funds investing mainly in domestic bonds, or they investing in foreign bonds, as well?
Jacobson: Well, several of them do have a foreign component. So, for example, PIMCO Unconstrained has at least 15% in emerging markets, which has helped it out. The Eaton Vance Global Macro Absolute Return fund is almost all non-U.S.; it has a lot of non-U.S. countries, and a lot of non-US currency. Of course, it's managed in such a way that it tries to be very, very short and low-volatility, but it tends to be mostly a foreign fund. The JPMorgan Strategic Income Opportunities [is invested] mostly in the U.S. So, they really do run the range there.
Benz: Eric, you mentioned PIMCO. What are the other big players in this unconstrained or nontraditional bond space?
Jacobson: The other two really big ones are JPMorgan Strategic Income Opportunities and Eaton Vance Global Macro Absolute Return. The JPMorgan fund tends to focus mostly on very short-maturity, short-duration high-yield credit with a lot of longs and shorts, I should mention. But its correlation runs highest to the high-yield category albeit on the short side in terms of duration and volatility.
Then the Eaton Vance Global Macro Absolute Return fund, also a very large offering, tends to use a lot of emerging markets, but it tends to be again on the short side and as well as have active currency bets in emerging markets, as well. It hasn't been exceptionally volatile, though it has been more volatile than the Barclays Capital Aggregate Bond Index, but it's also returned a little bit more, as well. And I am talking about the last three years.
Benz: Right. Now, you recently issued a research report, Eric, where you examined the risk/reward profiles of this whole basket of funds, and obviously, we have talked about what a broad gamut these funds run. But what commonalities did you see? Did you find that lower-volatility trend running across this whole group?
Jacobson: Well, it's interesting because if you look at the three-year records of the funds in the category, most of them do turn out to be a little bit more volatile than the Barclays Aggregate, which I think would surprise people. Now, that's not to say that they have been overly volatile. There have just been a few that take on pretty extreme positions that have been on the pretty volatile side; those tend to be relatively small funds that aren't doing a lot of marketing and gathering a lot of assets. But as I said, a number of them, even if they are marketed as absolute-return and low-volatility funds, have been more volatile than the Barclays Aggregate. The return pattern has also been generally a little bit lower. Now, I'd say actually, they kind of split more evenly, but there are a whole bunch of funds that have returned less than that benchmark, as well.
Benz: So, higher volatility and lower returns so far, and this is for the whole group?
Jacobson: Right there are exceptions, but there are quite a few that would surprise you with that kind of profile.
Benz: One other thing you noted in your research report, Eric, was that there is a general trend toward embracing credit risk at the expense of interest-rate sensitivity. Let's talk about that a little bit.
Jacobson: Sure. Well, there are, again, a couple exceptions. Putman tends to run things, for example, their 100 and their 300 funds with more, what I would, call structural mortgage risk for the most part. They use some mortgage derivatives in particular, and they generate a little bit more income that way and still try to keep volatility low. They have been reasonably successful. The majority of other funds have gone the way that I described, though, which is a little bit more credit risk, typically instead of interest-rate risk, or for example with the Eaton Vance fund, credit and geography risk, if you will, or market risk of emerging markets, for example.
Benz: Let's talk about you and the team's recommendations in this space, Eric. Are there any funds that you are recommending within this fairly young group?
Jacobson: Well, right now, the only fund that has a positive rating, if you will, is the PIMCO Unconstrained Bond fund with a Bronze Analyst Rating. Now, that doesn't mean that the other funds may not be worth a look. The rest of them that we do rate are rated Neutral, but those run a gamut. Some of the Neutrals that we have are sort of on the cusp and could eventually get one of our higher ratings once we develop a little bit more confidence in them. I would say that the JPMorgan fund and Eaton Vance fund both probably qualify as pretty high Neutrals, and we're very interested in them. We think that they are pretty good funds. We just haven't gotten the conviction yet that we want to recommend them.
Benz: So, Eric, what has nudged that PIMCO fund ahead of the pack?
Jacobson: Well, I think the big thing there is resources and experience. We know, for example, that Chris Dialynas, who is the manager, has run funds this way for quite a while. He's got a tremendous, tremendous bench of analysts and managers behind him, including PIMCO's investment committee, which is sort of Johnny-on-the-spot with regard to macro calls and just an enormous team of researchers both at the corporate level, at the emerging-markets level, and pretty much anywhere you might want to go with the fund like that. And in fact, that's a fund that has just an incredible number of different bets going on all at the same time, both longs and shorts and so forth, and it has a reasonable record going for itself so far.
Benz: So, would you say that it would be something that you would encourage investors to look for if they are looking for a fund that is opportunistic, that gives itself a lot of leeway? Would you want to see that research breadth in a lot different bond areas before recommending it?
Jacobson: Generally speaking, yes. I mean, it really depends on what the fund is taking on in terms of its domain. So, for example, the JPMorgan fund, which has a lot of resources around the country, but they are not tied directly to the team or the manager. He has them available to them if he wants to use them. But if you're just looking at his own team, like I said, most of the work that he is doing is in the high-yield space, and he seems pretty capable there. So, you have a degree of confidence.
If he were making all kinds of bets similar, for example, to the PIMCO Unconstrained fund, you'd want to see a certain level of commitment from all the other areas of JPMorgan. You'd want to know for a fact that they are really working together. And so far, we haven't seen anything that causes any concern. But like I said, as a general rule, whatever the domain of the fund is and whatever it commonly makes its bets in, you want to see that thick research bench there.
Benz: Eric, well, thank you so much for providing your insights on this rapidly growing category.
Jacobson: Glad to be with you, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.