PIMCO, JP Morgan, and Eaton Vance: Unconstrained

If you haven't heard of so-called "unconstrained" bond funds, you will. It's one of the hottest segments of today's mutual fund market: Morningstar estimates put the group's growth over the past 12 months at more than 260%, with its 20 or so funds bulging to roughly $44.5 billion at the end of February 2011.

Despite their modest number and only recent surge of popularity, the central idea behind unconstrained bond funds, some of which are also conceived as absolute-return bond funds, isn't new. The name is typically used to describe portfolios that (1) use a cashlike benchmark such as LIBOR, (2) can invest both long and short in the bonds and derivatives of nearly any fixed-income sector with wide limits on their weightings, and (3) have a very wide berth within which to manage interest-rate sensitivity.

Those Were the Days ...
The embrace of that last feature signals a nod to the old days. Although few funds advertised the same terminology, it was common in the 1980s and much of the 1990s for bond-fund managers to make big bets on the direction of interest rates, dramatically shortening duration (a measure of rate sensitivity), or extending it out to several years, with little regard to the anchor of a benchmark. Some employed considerable flexibility to invest across sectors as well. That began to change in the mid-1990s as most managers began adopting stringent, institutional practices, including the use of tight duration constraints and stricter attention to benchmarks. After some shocking trouble prior to 1995, for example, Fidelity's bond funds began to keep their funds' interest-rate sensitivities right on top of their respective indexes' and stripped risky allocations from funds that investors otherwise expected to be docile.

In fact, that ethos of tight duration control has become so entrenched in the best practices of modern bond-fund management that the re-emergence of unconstrained portfolios is, for better or worse, a bit revolutionary. With few exceptions, most managers have come to believe--and evidence strongly suggests--that it's extremely difficult to consistently predict and profit from the movement of bond-market yields. Even PIMCO's Bill Gross, who has done better than most with such bets, has made plenty of tactical mistakes. Overall, he has relied much more on sector rotation for his success and normally keeps his  PIMCO Total Return (PTTRX) fund's duration well within a range of 25% (plus or minus) around the Barclays Capital U.S. Aggregate Bond Index. In fact, yield-curve plays were PIMCO Total Return's most important contributors to performance in only three of the past 10 years, according to the firm's own analysis--and overall duration bets haven't occupied that honor even once.

Climbing a Lucrative Wall of Worry
Yet with interest rates at historic lows and Uncle Sam's debts at historic highs, millions of investors fear that a sustained march to higher bond-market yields is inevitable and all but imminent, and that the damage is going to be persistent and devastating. That worry is as intense as ever, despite considerable reason to think that the effect will be less catastrophic than many fear. (See this Vanguard paper for more detail on the case for being less fearful.) After shoving hundreds of billions of dollars into bond funds, which had been rallying on the back of falling Treasury yields and a credit-and-liquidity driven rally for most of 2009 and 2010, the wave has tapered, and investors have been desperate for an interest-rate refuge.

Nobody has better capitalized on that thirst than PIMCO, JP Morgan, and Eaton Vance. The first of those three launched  PIMCO Unconstrained Bond (PUBAX) in mid-2008 and put it in the hands of the media-shy PIMCO veteran Chris Dialynas, who had been running institutional money in a similar style for three years prior. He makes big-picture decisions with the help of Bill Gross and others on PIMCO's investment committee and delegates most bond-level selections to the firm's various specialist desks (as does Gross). Investors really began flocking to the fund in the middle of 2009, and the current of cash turned into a torrent in 2010. The fund had more than $15 billion at the end of February 2011, up from $1.7 billion in June 2009. (He and PIMCO also subadvise the no-load Harbor Unconstrained Bond  in the same style; it's also cheaper than PIMCO's retail share classes.)

Meanwhile,  JPMorgan Strategic Income Opportunities (JSOAX) has bulged to nearly $13 billion as of February, up from $800 million in mid-2009. Bill Eigen is the captain of JP Morgan's ship, having also taken the helm in late 2008 after running hedge fund money at JP Morgan subsidiary, Highbridge Capital, since 2005. Ironically, Eigen previously spent 11 years at Fidelity, joining that firm in 1994 right before it changed its entire approach to bond management. Eigen's investment team numbers around seven and is independent of the many other JP Morgan fixed-income teams scattered around the country, though he does draw from their expertise for sector and bond-level research.

Anonymous No More
Eaton Vance's ascent in this space has arguably been a bit quieter, but no less impressive. Mark Venezia runs a team that the firm says has been managing money for other accounts in the style of Eaton Vance Global Macro Absolute Return (EAGMX) since 1997, though the mutual fund was itself only launched in 2007. It has grown so large, so fast that the firm implemented a soft-close to new investors late last year. (Incumbent investors and other Eaton Vance funds are still able to add money.) The strategy also fuels a meaningful sleeve of Eaton Vance Strategic Income (ETSIX) and between the two funds accounted for $9.1 billion at the end of 2010. The same strategy is also replicated in a more-concentrated fashion at sibling Eaton Vance Global Macro Absolute Return Advantage (EGRAX), which recently boasted more than $600 million in assets.

In some ways, the Global Macro Absolute Return portfolio has shown itself more conservative than funds with similarly broad parameters, more carefully keeping its volatility in check. Yet it too has a wide berth within which to operate and focuses its attention mostly on the sovereign debt and currencies of countries all over the globe, including emerging and frontier markets. Its largest net long debt position was that of Croatia (3.9%) at the end of 2010, for example, while its largest net long currency exposure was the Egyptian pound (6.5%).

Too Clever by Half?
The ultimate question is whether these funds will do what so few have successfully managed in the past--generate competitive returns while insulating themselves from interest-rate risk. So far most have done a better job on the latter than the former, buffering overall portfolio risks with cash while still investing in aggressive sectors. Among this small group, only the two managed by PIMCO lost money when yields spiked in the fourth quarter of 2010.

Still, there's no telling if and when extreme protection from rising yields will be most valuable. In the meantime, the very small group of unconstrained funds around for more than a year saw a wide dispersion of 2010 returns, averaging a 5.5% gain. And while that was a fat margin over the paltry 0.34% return of three-month LIBOR, it was more than a full percent behind the Barclays Aggregate Index and roughly 240 basis points (2.4%) behind the average intermediate-term bond fund, which normally takes on more interest-rate risk but a lot less credit and sector risk than most unconstrained funds have chosen to pursue.

One important factor standing in the way of bigger gains among unconstrained funds has nothing to do with fund strategy, though. The group is dominated by firms that distribute funds primarily through traditional load channels and sports a median expense ratio of more than 1%, which is high, even relative to the pricey universe of front-load, intermediate-term bond funds. With market yields currently running close to historic lows, those hurdles will clearly be difficult to overcome.