Can This Fund Outsmart Global Bond Markets?

This week, we published a new Morningstar Analyst Rating of Bronze for

Home Base The team at Wellington Management Company, this fund's subadvisor, isn't the first to note the pitfalls of tethering a strategy to global-bond benchmarks, but it has crafted its own unique brand of benchmark-free global-bond investing. Rather than simply substituting developed-markets exposure with emerging-markets debt or other sectors that can heighten volatility, the team is focused on meeting investors' expectations for a core bond allocation, namely to damp volatility and provide safety when equities struggle. To that end, the team invests the bulk of the fund's assets in the debt of a core group of countries that it thinks will hold up well during periods of heightened volatility (referred to as the fund's core or home-base portfolio). Countries included in the home base should have stable-to-improving fundamentals, attractive valuations, and highly liquid debt markets.

The fund's process avoids the conundrum of market-weighted debt indexes by investing equal allocations across home-base countries, with one exception: emerging-markets countries, which are more susceptible to bouts of illiquidity and volatility, receive half the weighting of developed-markets countries. Lead manager Mark Sullivan makes infrequent changes to the home-base portfolio's duration, either investing across the core countries' yield curve from one- to 30-year maturities, or, when switching to capital-preservation mode, one to 10 years. Sullivan turned even more cautious on interest-rate risk recently, shifting the home base into maturities ranging from one to five years in early 2016.

Currency selection is handled separately from the country decisions, but the goal of limiting volatility and protecting on the downside still applies. In constructing the fund's core currency exposure, the team first determines the optimal amount of U.S.-dollar exposure. In general, the team has believed that the U.S. dollar is on a multiyear appreciation trend, which has led the fund to have a fairly high exposure to the dollar (typically 70% or greater, though it has been as low as 42%). When the fund moves away from the dollar as a core position, it shifts into a subset of the most-liquid developed-markets currencies. That approach differentiates the fund from world-bond peers that run either fully hedged or completely unhedged strategies. It's also different from managers that take a fully active approach to currency management and have at times made much bigger shifts in currency exposure, a tactic that can amp up volatility, for better and for worse.

Over time, this approach has produced a core portfolio that looks distinct from global-bond indexes and many peers. Japanese government bonds have never made the cut, and negative yields and worsening fundamentals led to the removal of some European countries over the years. The team removed Germany from the home base in March 2015, for instance, as the European Central Bank's quantitative easing pushed intermediate German bund yields into negative territory. Countries that play a relatively minor role in global-bond indexes that had made it into the home base as of June 30, 2016, include Denmark and Norway (each at 16% of assets) as well as emerging-markets countries Mexico and South Korea (each at 8%). Lately, the team has been hard-pressed to find countries with improving credit profiles, resulting in a core portfolio invested across just seven countries as of June 30, down from 13 at the time of the fund's 2011 launch. By the end of June, the fund's core portfolio, which has exceeded 80% of assets at its highs, dropped to a new low of 57%.

The Hand-Off The fund's home-base portfolio has played a big role in distinguishing it from the market, but from there, the process takes another turn toward the unusual. Typically, the decision-making at bond funds is concentrated in the hands of one individual or a small group of managers who decide which sectors to allocate to and when, but that's not how things work here. In populating the rest of the portfolio away from the core (referred to as the opportunistic portfolio), Sullivan doles out allocations to specialist managers who have demonstrated a high degree of investment skill in the past. These managers independently run absolute return strategies (with the ability to invest long and short) in their respective areas of focus, whether developed-markets duration, currency, corporate credit (investment-grade and high-yield), securitized credit, and local emerging-markets debt.

The underlying managers are responsible for determining whether their respective markets exist in one of three states: attractive and contains idiosyncratic opportunities, not attractive but still contains idiosyncratic opportunities (in which case, they can hedge out market risk using credit default swaps on indexes), neither attractive nor contains idiosyncratic opportunities (in which they give cash back to the home base). That puts the onus on the specialist managers to signal to Sullivan when the environment for their strategy is good or bad. They get rewarded for a well-timed decision to return capital to the home base as much as they do for putting money to work at opportune times. While each of these managers runs a sliver of the total portfolio, the tactical calls of managers in this group can have a sizable impact on portfolio positioning. For instance, dislocations in corporate credit markets in 2015 and early 2016 signaled opportunity to the fund's corporate specialists. Net corporate exposure more than doubled here to 22% from 8% in the first half of 2016.

Rather than dictating portfolio positioning from the top down, Sullivan spends his time as lead manager monitoring the risk profiles of the underlying strategies and their impact on the risk of the portfolio as a whole. This oversight helps prevent the fund from building unintended concentrated exposures to individual risk factors. Sullivan also closely tracks the correlations between underlying strategies--the lower the better--which is another way the strategy seeks to add value while minimizing the deleterious impact of one or two poor decisions.

The Verdict The fund's performance profile so far suggests this team has hit on something. For the five years through Aug. 31, 2016, the fund returned 3.0% annualized, outpacing roughly two thirds of the world-bond peer group (comparing distinct funds) and the Citi WGBI's meager 0.2% return. Moreover, the fund achieved those returns with less than half the volatility of the index and the Morningstar Category norm. The team expects roughly half the fund's returns to come from the home base and half from opportunistic strategies over time. So far, that split has been tilted more toward the home base, from both country and currency selection. But contributions from opportunistic credit and macro strategies have still been positive, and the team notes that the macro strategies have been instrumental in limiting downside risk.

Our continued confidence in this strategy rests in the skill of Wellington's talented fixed-income investment team, which doesn't lack for experience or breadth across any of the areas in which the fund invests. The focus on assembling a portfolio of uncorrelated views and limiting downside volatility, which is hard-wired into the fund's process through daily risk monitoring and Sullivan's oversight, should also continue to prevent the fund from getting too far off its intended course, despite the absence of benchmark constraints.

Admittedly, the fund's offbeat approach can hold it back relative to the pack at times, particularly when big global-bond benchmark constituents are notching gains in defiance of their poor fundamentals and already stretched valuations. Amid another ferocious rally for global-bond yields in 2016, for instance, the fund has lagged behind. Its 3.4% gain for the year through Aug. 31, 2016, while respectable in absolute terms, trailed the category median and Citi WGBI by a margin of roughly 4 and 7 percentage points, respectively. The fund's increasingly cautious stance on duration in early 2016 didn't help, nor did its ongoing exclusion of an appreciating yen. Given the team's ongoing aversion to negative yields, investors here should get used to sitting such rallies out for now.

Over the long term, we expect the fund's successes will continue to outshine these temporary setbacks. We're less sanguine about its chief drawback: high fees. This fund's ingenuity notwithstanding, the most surefire way for a bond fund to get a jump on its competitors is to pass more of its returns directly to investors through low fees. In today's exceptionally low-yielding environment, every basis point counts.