3 Things Your Bond Fund Manager Doesn't Want You to Know

Until you've done it for a while, being a Morningstar analyst can be a dizzying experience. We spend our days meeting fund company managers and executives, all of whom seem to have decades of experience, incredible resumes built around gilt-edged business degrees, and time working in rarified strata of the investment industry.

Eventually, though, you realize that even when many of those things are true, fund managers are still human beings. They all face daunting day-to-day challenges in managing money and running their businesses, even if most of them are well practiced at painting a picture of themselves and their colleagues as the most content people on earth, who have managed to short-circuit the basic laws of business and investing. Here are a few areas that most managers will never talk about, but with which just about all of them struggle on a daily basis:

1) We don't really have as many bodies as we'd like covering all the sectors in which we invest. It's difficult to imagine in today's world of mammoth money managers with globe-covering staffs, but most fixed-income groups have areas of staffing that are leaner than they'd like.

There are rules of thumb that most use to estimate how many individual corporate credits an analyst should cover, for example, but it works to the advantage of an operations executive for that to be a larger number. If you personally manage a portfolio of bonds, though, you'd much rather have analysts with fewer names to worry about, to which they can devote more energy and thought.

Few managers will ever admit publicly that they're lacking more than perhaps a couple of analysts. But outside of the bulge-bracket firms that have massive asset bases to support big teams, most firms are under pressure to keep staffing lean. Naturally, there's some kind of optimal balance between protecting their margins and having a robust investment staff, but it's easy to see the impact of the former on budgets and profit-and-loss statements.

The importance of staffing may not become obvious until a big market crisis develops, or some other circumstance lays bare the fact that a team simply doesn't have the manpower necessary to adequately cover a particular sector. By then, of course, a lot of damage may have already been done.

2) There are some things we're much better at than others. This one probably seems obvious, but you'll rarely hear it from most money management firms. Part of the reason owes to the existence of those bulge-bracket managers who represent themselves as being the best at everything they do. That's a hard image against which to compete, and especially true when many investors allocate the bulk of their assets to just a couple of bond managers.

But the truth is that even the biggest firms do some things better than others. The point isn't necessarily just that everyone has weaknesses, but that most have some particular strengths that have been determined by company culture, tradition, and roots. Most firms start out small with a specialty upon which they build a bigger business. Some are able to do so smartly and effectively--usually those built on an investment culture nurtured by capable managers, rather than those birthed from a bank, insurance, or marketing-focused company intent on building investment products and then finding managers to run them.

When Bill Gross and a few colleagues founded PIMCO decades ago (with the support of insurer Pacific Life, ironically enough), they did so primarily as a manager of corporate bonds. Their success in branching out and developing world-class expertise in other areas was an unusual feat. Plenty of firms have tried to achieve similar success, often by hiring experts to come in and build new teams, or even by "lifting out" entire existing teams from other firms, often with mixed results.

Sometimes the strongest indicator of a firm's confidence in its capabilities is right there in the asset mix of its diversified portfolios. Those that lean heavily on a particular sector will often argue that they do so because that's where they've historically "found the most value" in the marketplace. Coincidentally, that's often the same sector on which the firm's leaders focused for most of their careers.

3) How much we charge you matters just as much to our fund managers as it does to you. The amount of ink Morningstar spills on fund expenses drives most asset-management firm executives to distraction. Whether they believe it themselves or not, most would like you to think that there's a direct, proportionate, and tight relationship between how much they charge and the quality of the investment management they provide.

But buying the services of an investment manager isn't the same as buying say, a snowblower. With the latter you might face a choice between three or four models with a different mix of features, bells and whistles, and perhaps even some variability in the quality of their parts. It's not as easy to make those kinds of distinctions among asset managers. That's especially so in bondland, where most have years of experience and diplomas from the best business schools in the country.

Even the most talented among them know, however, that when they get up every morning, they have to look your expense ratio right in the eye and figure out how to overcome it.

That's because, no matter how smart they are, bond managers know that they're competing against other very smart people, and in markets whose pricing efficiency isn't measured in percentage points but rather basis points. And every single basis point built into your expense ratio is one that a manager has to earn somewhere in the bond market just to get to even. Only then can he or she even think about generating enough return to beat your fund's peers.

All things being equal, your mutual fund company wants to charge as much as it can get away with. But the individual manager of your fund would actually love for it to be the cheapest of its peers. Every dollar less you pay in fees is one that your manager doesn't have to struggle to earn before even focusing on providing you with a competitive return.

What to do? It can obviously be difficult for an outsider to judge where a firm has--or lacks--deep-enough resources. But one way to address the problem is to bring a healthy dose of skepticism when looking at new funds that focus on strategies or sectors outside of a firm's traditional areas of expertise. You shouldn't be surprised to see that kind of mismatch, especially if a fund is the 10th newly minted competitor with a strategy that has recently brought billions of new dollars into the portfolios of its peers.

Meanwhile, the aforementioned cost issue can really drive your manager astray if the price is high enough. That's because there will be unrelenting pressure to take a little more risk to close the yield and return gap with cheaper competitors. It may not seem like much when the difference is 20 basis points, but over the long term, a portfolio that constantly needs to produce that much more return than its rivals will, by definition, need to take more risk of one kind or another.

Fortunately, focusing on a pool of fairly priced funds is one of the easiest steps to incorporate into a fund selection effort. Low expenses might sound like a broken Morningstar record, but hopefully that's a small price to pay compared with the high cost of a broken investment.