Non-Traditional-Bond Funds: Getting It Wrong

Bubble Baby Sometimes, mutual fund categories become disasters. The "government plus" funds of the 1980s attracted tens of billions of dollars from investors who thought they were buying safety, but landed long bonds instead. They soon learned the difference. More spectacular yet was the flameout by high-growth and technology funds, following their huge inflows during the late 1990s. What went up, it turned out, could very much go down.

By those standards, the troubles of non-traditional-bond funds have been negligible. Such funds have been mild disappointments rather than an industry scandal. Their story is more farce than tragedy. Nonetheless, it is instructive, illustrating how fund marketers fail investors, and the advisors who serve them. Funds that are sold and bought improperly are likely to be funds that are used improperly. So far, that has been the case with nontraditional-bond-funds.

The category emerged after the 2008 financial crisis, when interest rates sunk and bond prices rallied, leading to what future Nobel Laureate Jeremy Siegel called “The Great American Bond Bubble.” In that belief, he was not alone. Many pundits warned that interest rates had fallen about as far as they could and were likely to reverse course. If so, most bond funds were in trouble. They had no place to hide when interest rates rose.

Thusly were conceived non-traditional-bond funds—a bubble baby, as it were. Carrying names like “absolute return” and “tactical” and “unconstrained,” such funds suggested the ability to make money regardless of the investment trends. Conventional-bond funds would always have positive durations, of intermediate length, and thus would always be punctured by interest-rate spikes. Non-traditional-bond funds were different. They were funds for their times, funds that were constructed to withstand the popping of the bond bubble.

Not According to Plan Which leads to the first problem: Fund-company product managers can't predict financial markets, any more than the rest of us. Non-traditional-bond funds anticipated an event that did not happen. (If the bond market does blow up anytime soon, those who forecast its doom in 2010 don't get to claim that they were right. They were not; their statute of limitations has long since expired.) The same held true for the rash of tactical asset-allocation funds that followed the 1987 and 2008 stock-market crashes, which presaged not further downturns, but rather prolonged rebounds--and for Shearson's 1990s Fund, established to pounce on that decade's trends. It lasted until…1993.

The second problem follows closely from the first. Funds that are bought on an investment thesis are often sold when that thesis does not occur. Sure enough, after enjoying several straight years of net sales, non-traditional-bond funds suffered net redemptions in 2015, and then again for the first 11 months of 2016. In all, they have shed about one third of their peak assets. If bonds do head south, non-traditional-bond fund investors will have mistimed their purchases, buying into the category when its protection was not needed, and then cashing out before receiving the benefits.

Adding to the confusion are the category’s portfolios. Many non-traditional-bond funds cite the possibility of carrying negative durations when necessary, so that they could profit during what otherwise is a bond bear market. (And, as stated earlier, many other funds that shy away from making such explicit promises, do so implicitly through their names.) That is, they indicate that they will time the market--a feat that few fund managers dare to attempt, and even fewer do so successfully.

In other words, the category talks big and walks small. True, most non-traditional-bond funds adjust their durations more than do their conventional cousins, but they rarely go negative. Durations are typically short to intermediate. Such positions make the funds fairly resistant to interest-rate rises, but not impervious. When other bond funds decline, they generally decline, too.

Down the Credit Ladder At this point, you may be wondering how non-traditional-bond funds make money. Short-to-intermediate securities pay little these days--which becomes even less after 1.13 percentage points of annual expenses are extracted, which happens to be the non-traditional-bond fund average. (Fancy strategies beget fancy prices; on average, staid intermediate-bond funds cost just 0.66%.) What's left for the shareholder?

Not much, if the non-traditional bond fund restricts itself to high-grade securities. For that reason, most funds move well down the credit ladder. The average intermediate-bond fund has 90% of assets in investment-grade credits, including just over 50% in U.S. government guaranteed securities. Comparable figures for non-traditional-bond fund funds are 60% and 25%, respectively. Conversely, the amount in BB/B issues is just 6% for the intermediate funds, and a full one third for nontraditional funds.

The typical non-traditional-bond fund can be thought of as a hybrid between an investment-grade and a high-yield index. That is not a comparison that the category would relish, as a hypothetical fund that consisted 50% of Barclays Capital U.S. Bond Aggregate Index and 50% Merrill Lynch U.S. High Yield Master II would have beaten the non-traditional-bond fund average in 2011, and then in 2012, and then in 2013, and then in 2014, and then again this year. Only in 2015 did the non-traditional-bond funds triumph. But they still lost money that year.

Knowing When to Say No Non-traditional-bond funds haven't caused much harm. Most have eked out steady, modest profits; and while the category's performance has lagged the average for the intermediate-bond group that it sought to replace, the gap has been modest. So, it's hard to get too fussed about the matter. On the other hand, the category has delivered no blessings, either. If fund marketers had never had this particular bright idea, the world would have continued turning, slightly more happily for its ignorance.

As Morningstar's Don Phillips likes to say, fund companies tend to define themselves by which funds they choose not to offer. Care to guess when the fund industry's marketplace leader--the largest purveyor of mutual funds in the world--launched non-traditional-bond funds? That's correct: Never. Good call, that.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.