Tue, 10 Jun 2014
The big names in this category have more to prove before we can fully recommend them, says Morningstar's Eric Jacobson.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
The nontraditional bond category has been growing by leaps and bounds, but a handful of funds have been capturing most of the assets. Joining me to discuss the three largest funds in the category is Eric Jacobson, he's co-head of fixed-income manager research for Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Great to talk to you Christine.
Benz: Before we get into these specific funds and your opinion of them, I would like to talk about the nontraditional bond category. What are the general characteristics of the funds that land in this group?
Jacobson: The biggest component of the group is a bunch of funds that generally think of themselves as being unconstrained, and that typically means they have a really broad range available to them in terms of, not only the sectors they can invest in, but the amount they can hold in those sectors, and so on. Think, for example, of very large allocations to high yield or emerging markets. They can even generally do some currency.
And the other axis there is interest-rate sensitivity, duration. They have the ability in most cases to actually go negative a little bit in terms of duration and very often can go extremely long as well. So, in theory, at some time in the future, perhaps they could be building up a lot of rate sensitivity.
Right now they all tend to cluster, for the most part, around being relatively short in the one- to three-year range in terms of duration, with exceptions in both directions, and some of them being very tactical.
Benz: I wanted to get your thoughts on the three largest funds in the group. Let's start with the biggest--that's JPMorgan Strategic Income Opportunities. Let's talk about the general complexion of that fund and also Morningstar's view on that holding.
Jacobson: This fund is run by a fellow named Bill Eigen. He's very well-known in the industry, and he's a really a great speaker, by the way.
He has the entire tableau of investments available to him, but his history has mostly been focused on high yield. A lot of that has been relatively short-maturity high yield. I don't want to leave out the fact that he's doing a lot of other things in the portfolio, which he is very keen to talk about, including things that typically go on in hedge funds, like relative-value trades and things like that. But the dominant effect, for the most part, has come from that high-yield piece.
He has very importantly raised and lowered cash quite a bit, and so not only has he taken on less risk--so he hasn't been entirely moving with the high-yield market in terms of return volatility--but he has trimmed back that allocation, as high yield has gotten more expensive, for example.
We really like what we've seen so far from this fund, but we haven't given it a strong recommendation yet, in part because, according to Eigen, the market has really presented itself with high-yield opportunities over the last several years, and so that's why he's been focused so much there. But we haven't really seen how and what he might do in a different kind of marketplace with other sectors. We'd really like to see a little bit more of that and better examples of that before we come to strongly recommend the fund.
Benz: We've got that fund as well as the other two funds at a Neutral Morningstar Fund Analyst Rating now. None of them earns a Medalist rating at this point.
Jacobson: That's right. I would point out, and it's important to realize, that is not the same as a Negative rating. It doesn't mean we think people shouldn't buy it. It's just that we haven't achieved a comfort level yet where we really want to make a recommendation, and as soon as we get into the Bronze, and certainly Silver and Gold ratings, that is much more akin to a recommendation.
Benz: The next largest fund in the group is PIMCO Unconstrained Bond. It now has a very famous fund manager. Let's talk about it. It, too, has a neutral rating. Let's talk about its positioning, both in the past, as well as under Bill Gross, as well as your forward-looking outlook for the fund.
Jacobson: In terms of the positioning, this is one of the most interesting funds in the category by virtue of its divergence from the crowd. What I mean by that is, a lot of the funds in this category have given up some interest rate risk, quite a bit of it in fact, but are still feeling competitive pressure to produce generous returns, and have taken on some meaningful measure of credit risk. And by contrast, the PIMCO fund has not really done that very much.
You see this in the correlation numbers, as an example. When you look at the correlation for the category as a whole--and by the way even this fund's chief competitors--you find that they have very little, if any, correlation to Treasury yields, for example, or even just the Barclays Aggregate--the core part of the bond market. But they tend to be very highly correlated in many cases with high-yield indexes or bank-loan indexes--not always the amount of volatility that those indexes have, but they are much more highly correlated there. This PIMCO fund really has gone betwixt and between. Its correlation is really split between the Barclays Aggregate and the high-yield index, and that's unusual for the category.
The downside of that, in part, is that the fund has had more interest rate risk at the wrong times a couple of times in the last few years than would have been desirable, I suppose, and not necessarily because it was making big bets in one direction or the other. It found itself behind in the summer of 2013, for example.
So it's very tricky, because we think that there is a lot of skill there. As you mentioned, Bill Gross is running the fund now. I do think he is going to be, in some ways, more aggressive than Chris Dialynas was. But we really want to have a better sense that they can find that balance really well with this portfolio before we make any kind of recommendation.
I think one thing for people to watch is, in general, I would expect its returns not to be in sync with a lot of the others in the category, and overall it may not have as high a level of returns in all cases, but it also won't have quite the same credit risk that most of them do.
Benz: I'm hoping you can address what might, at first blush, appear to be a contradiction in that we've got PIMCO Total Return at a very high Medalist rating, and yet we've got this PIMCO Unconstrained Bond--same manager, even more flexible mandate, which arguably is something you want Bill Gross to have--at a Neutral rating. Why is that?
Jacobson: Absolutely I agree with you that, in theory, you would want to view this as the best possible repository of all PIMCO ideas, including those of interest rate sensitivity. Whereas, with PIMCO Total Return, you have those bets implied in the positioning, but they're limited in how far away Gross can make them from the Barclays Aggregate--whereas PIMCO Unconstrained has a tremendous amount of range.
So in theory, we do think that this fund has the potential to be really, really good because, as you suggest, it has all the resources and the capabilities of the firm, and the capabilities of Bill Gross himself. The tricky thing to this point has been this correlation issue.
I will mention, by the way, that PIMCO takes issue with the way we think about it, I think in part because they've looked at shorter time periods and seen less correlation to the interest-rate-sensitive parts of the market, but when we look overall over the last few years, that's what we're seeing.
I think the hard part there is really just how to frame this for investors. Even though that may not in on of itself be a huge problem, you also have this issue of expectations. I think, to some degree, they've positioned the fund as being capable or likely to meet or exceed the returns of PIMCO Total Return, and at the same time be sort of an absolute-return vehicle. I think that's going to be very, very hard to achieve. We really want to see a little bit more rubber meeting the road here.
The last point I would make is that, some of these things, especially when you're talking about taking duration short and even negative, it's a little bit of a different ballgame than what you're used to with a regular, long-only bond manager. So, we want to see a little bit more there as well.
Benz: The last fund that I'd like you to cover is Goldman Sachs Strategic Income. This is the third-largest entrant in the non-traditional bond category. Let's talk about its positioning, at least thus far, as well as its forward-looking prospects. Again, this one is a Neutral-rated fund as well.
Jacobson: This one is a really interesting fund, because it combines a couple of features, one of which is that it has done generally pretty well. It's only been around for less than five years, so we don't have a really long history. But it has navigated a couple of really nasty markets, or at least tricky markets, over the last few years. Its return, as of yesterday, was within the top fifth percentile of the category, which is obviously very, very strong.
What's tricky about understanding that, though, is that, to a large degree, that success has come as a result of some very tactical decisions to ramp up credit risk or to strip it out of the portfolio and also to do the same thing with duration occasionally. There have been times, for example, when it's had a negative duration, or zero duration, even more so than many other funds.
And that takes us to this question of, why isn't it a recommended fund right now, even though it's had that great performance? The bottom line, at the moment at least, and we're still sort of evolving with this, but at least at this point, we see such tactical maneuvering here, such a great deal of it, and in such short time periods, that one of the things that gives us a little bit of concern is, it would be very hard for an investor to get their mind around … If we have another market that looks anything like the third quarter of 2011, where risk assets sell off, or we have another market like the summer of 2013, what can we expect from this fund?
Those are questions you can usually answer based on the style and the history of a lot of other managers. But for this fund, it's going to be really, really hard to know, will the manager make that timely and correct and big call at a time of a crisis like that? Or will they get caught flat footed? There is no way really to know for sure if they're going to be able to do that repeatedly. It's pretty hard. We haven't seen that historically in very many managers.
Benz: So this is by far the most tactical of the three?
Jacobson: I think that's right, absolutely.
Benz: Eric, thank you so much for being here to share your insights on these three big and growing funds.
Jacobson: My pleasure, Christine, thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.