Tue, 11 Jun 2013
Investors should be cautious of rapid inflows into high-yield and bank-loan funds as managers could have difficulty putting excess money to work in high-conviction ideas.
Christine Benz: Hi. I'm Christine Benz for Morningstar.com. As investors have flocked to higher-yielding bond categories, asset growth could be problematic at some of these funds. Joining me to discuss this topic is Eric Jacobson. He is a senior fund analyst with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Sure, Christine. Glad to be with you.
Benz: Eric, we've generally said that investors shouldn't get concerned about big asset inflows into some of the general bond categories, core intermediate-term funds, for example. Let's talk about why that is. Why can managers of such funds typically handle a lot of assets without it compromising their performance?
Jacobson: I think that the rule of thumb is that the more plain-vanilla a portfolio and its strategy are, generally speaking, the easier time it is going to have absorbing that ton of cash, mainly because the big sectors represented in the broad bond market indexes are very, very liquid. We're talking about Treasuries; we're talking about agency-backed mortgages. Even the corporate investment-grade market, which is smaller and a bit less liquid than the others, still generally has a lot of capacity in order to absorb that cash, and funds with a lot of resources can also use derivatives sort of as a placeholder while they're putting that money to work. That may not always be what you want to see if they're doing it for a long period of time. But there are tools that they can use, like I say, to absorb that cash, and it's a lot easier for a core fund.
Benz: Once you step beyond those core, very vanilla-type funds, you say that there might be actually some risk in these big asset inflows. I'd like to start by looking at some of the categories that have recently seen some of the biggest flows. One is this nontraditional bond category. It's a new category for us. First, let's discuss what that category is? And second, let's discuss why you think in some cases flows could be problematic?
Jacobson: One of the interesting things about the category is that it's a little bit more defined by what the funds are trying to do than what is in them, and I'll circle back to that in a minute. Most of these funds are trying to produce some sort of what we might call an absolute return. In other words, just beating a very basic benchmark like Libor by a certain amount each year with the hope of not generating negative returns. And as we've talked about before, the most common way to try and do that in this environment has been limiting interest-rate risk. So, in many cases what managers are trying to do is, is sort of sell it as an all-weather portfolio or diversion of something else that they already manage, just without interest-rate risk in the hope that they can deliver a steady return.
Now going back to what I said before about what's in the funds, that makes a big difference, and some of them have very different features than others. Some of them have lots of credit risk. Some of them take on more structural risk we might call it. The Putnam funds that are in the category, for example, use mortgage derivatives to generate more yield and to try and generate more consistent yield than some of the other portfolios. And some of them, as I suggested earlier, are sort of broad multisector core funds and drag almost. PIMCO Unconstrained Bond, not necessarily core underneath completely, because it has flexibility to take on more credit and emerging-markets risk, but it's sort of the best-ideas fund. It has a very large set of tools at its disposal. And it is not necessarily concentrated in the higher-yielding, lower rate-risk areas of some other funds, but it does hedge its interest-rate risk out.
Benz: So, obviously a very broad basket of funds doing a lot of different things. Which types of funds would you tend to be most concerned about when it comes to the velocity of asset inflows that we've seen recently?
Jacobson: Those that are more dependent on--and it's no secret, of course--smaller, less liquid markets are the ones that you probably want to watch the closest. The JPMorgan Strategic Income Opportunities fund has been a decent fund. It has a very decent strategy. I'm not knocking it for this. But it has been one of the faster growers, and it does have a lot of exposure to the high yield market. I wouldn't necessarily scare people away based on what I have seen with that fund, but that's an area that you want to keep a close eye on, and there are several other funds like it in the category.
Benz: So, would having a big weighting in high yield be a potential yellow flag if that intersects with big asset inflows?
Jacobson: Absolutely. I think a lot of times what you want to also look at is how big is the fund to begin with, what share of the fund is in these new flows, and in the case of high-yielding bank loans, does this manager manage high double-digit numbers? And when I say high, I'm talking about $20 billion, $30 billion, $40 billion in the sector, and at that point you have to worry about the ideas getting diluted, and maybe owning a little too much of the market.
Benz: I think that's an important point, Eric. You're saying don't just focus on your fund in terms of the dollars that the manager might have in, say, the high-yield sector, but look at how much overall that the fund manager has in that particular area of the market.
Jacobson: That's right. And it may seem like the kind of thing that isn't that easy to find, but it actually is. Most fund websites will tell you how much they manage in a particular large area. And if they don't have it on the website, just pick up the phone and call them because every fund firm has that information somewhere, and they should be able to deliver pretty easily.
Benz: You mentioned bank loans in passing, I'd like to look at that category specifically. That has been just a huge asset gatherer like the nontraditional bond category. Let's talk about, why big flows into some of these funds could potentially be problematic?
Jacobson: The biggest issue there is liquidity. The bank-loan universe tends to be a lot less liquid than the bond universe in general, or say, the high-yield bond universe even because bank loans are not actually securities that are traded on a more private basis than regular bonds are. They take longer to settle, and they just don't move quite as quickly as other bond sectors do. And so, you also have the issue that only a certain portion of the market that is actually bank loans per se, is traded and syndicated out into the marketplace. We're talking about several hundred billion dollars, but we're also saying that several hundred billion have flowed, if you will, into these funds.
Benz: Eric, I'm wondering if you can share any sort of quickie ways to tell if potentially flows have been a factor for a fund and could be problematic in the future. As I'm looking through the portfolio, apart from looking for high-yield securities and bank-loan funds, are there any other things that would potentially be yellow flags for me?
Jacobson: Yeah, I'd say--again, this is particular to the bank-loan and high-yield categories--I wouldn't use this marker for a broad investment-grade core fund because of the way that they manage interest-rate sensitivity. But in the case of these other categories, the amount of cash in the portfolio can tell you something because if the fund is taking in lots and lots of investor assets and having trouble putting that money to work in ideas that they really believe in and have a lot of conviction about, they're going to likely start to build up cash in the portfolio.
The other thing that you might see is them try to deploy that cash in a placeholder, and so that might in some cases now be exchange-traded funds that you see in the portfolio, or you might see derivatives. They might appear at the end of the portfolio, and in particular, you might want to look for baskets that represent say 100 loans or 100 bonds, and those usually are marked by the name CDX.
Benz: So that would indicate that maybe the manager is trying to deploy a whole bunch of money all at once?
Jacobson: Exactly. Usually just trying to hold the place and at least deliver a marketlike return while they're trying to get that cash deployed.
Benz: Just to play devil's advocate on the question of cash. If I see a fund with cash that is invested in one of these sectors, is it possible that that's just sort of a prudent management technique? If a lot of flows have come in, maybe the manager is figuring that the money could easily flow out the door if investors turn sour on the category?
Jacobson: I certainly agree with you that that is a possibility, and there are a lot of managers that I would probably laud for doing it. On the flip side, I would criticize the fund companies that they work for, for perhaps not giving them the flexibility to close the fund even on a short-term basis. We don't see it that often, and because of that I think a lot of firms are loath to do it. They don't want to be the firm that closes a fund while everybody else is raking in the cash, but one that really has your best interests at heart will probably consider doing it even on a short-term basis.
Benz: It's been a pretty small handful of bond funds that has actually closed to new investors, correct?
Jacobson: Absolutely. I don't have the number handy in my pocket, but you could probably count them on two hands.
Benz: Eric, well, thank you so much for being here to discuss this potential risk factor for newly arrived bond-fund holders.
Jacobson: My pleasure, Christine. It's great to be with you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.