News, Vision & Voice for the Advisory Community
An article by LPL's Adam Cohen and Google's Jingwei Lei in IMCA's publication flukily conicided with the revelation of Bill Gross's new job managing just such a fund
October 13, 2014 — 6:46 PM UTC by Sanders Wommack
Brooke’s Note: At first glance, an unconstrained bond fund, just the name, seems like the investing version of a concealed firearms license. Maybe it is. Based on the definition as I read it in this article, an unconstrained bond fund — with room for derivatives and shorting — sounds a lot like a hedge fund. The esteemed authors (one employed by LPL and the other Google, but ex-Fortigent) of the article, Unconstrained Fixed Income, Really? saw things a little that way — and I love their headline. But when I put the best quantitative, analytic mind we have in our writers stable on the job of examining it, he begged to differ. I’m not sure precisely where I come down on this complex matter but with Bill Gross now synonymous with this hot category, I am glad, thanks to Sanders Wommack, we can show two very contrasting takes on the subject here.
Hard upon Bill Gross’s leap from PIMCO to Denver-based Janus Capital Group Inc., an article co-authored by an LPL Financial wealth management vice president and a Google portfolio analyst warns of the inherent perils in exactly the kind of fund Gross now manages.
The article, Unconstrained Fixed Income, Really?, which appeared in the September/October issue IMCA’s Investments & Wealth Monitor, examines Morningstar-sourced performance and allocation data of unconstrained funds over a three-year period to determine how flexible and diversified those funds actually are.
“Our study suggests that investors need to be cautious when allocating to unconstrained fixed-income funds” says the article by Adam Cohen, vice president of wealth solutions at LPL, and Jingwei Lei, a portfolio analyst at Google Inc. According to the article, investment in the space is “potentially treacherous” and that the sector overall exhibits a dangerous bias towards corporate credit.
The article may have given rise to second thoughts to anyone thinking of hitching their wagon to Bill Gross on his trip into the wild west of fixed-income investing, Perhaps it even accounted, in small part, for the paltry $66.4 million net inflow to the Janus Unconstrained Bond fund while billions were shifting to BlackRock, DoubleLine, Vanguard, and TCW Group. See: How RIAs are managing the Bill Gross problem — from firing his old PIMCO fund, to detailed letters to clients to taking a good look at Janus.
Just how treacherous?
L’affaire Gross aside, the article appears at a time when the popularity of unconstrained funds is high and their merits — or lack thereof — are much-discussed. So I took a close look at the underlying data and conclusions reached by Cohen and Lei and came to significantly different — in some instances polar opposite — conclusions. See: How Janus CEO Richard Weil’s Bill Gross hire completes the PIMCO-ization of the Denver equity shop.
For the purposes of the IMCA article, the authors define an unconstrained fund as those defined as a “nontraditional bond fund” by Morningstar, plus a handful of others with key words like “strategic income,” “opportunities” and “unconstrained” in their names. In such funds, “portfolio managers may take both long and short positions to produce exposure to any level of risk and, likewise, the use of derivatives in addition to cash bonds is common.” Both authors declined my offer to discuss the views expressed in the article.
To support the “potentially treacherous” thesis, the article provides two risk vs. return charts.
The first (Chart 1) shows risk and return for unconstrained bond portfolios between November 2012 and November 2013. Return is graphed on the Y-axis and risk, as measured by standard deviation percentages, is measured on the X-axis. The second chart (Chart 2) looks at the same metrics but examines core bond portfolios.
(When contacted by e-mail for a response to any of the conclusions reached by this article, Cohen and Lei declined to comment.)
On second look…
On the most basic level of analysis, it appears core portfolios were the real danger of 2013, as unconstrained funds handily outperformed them. In fact, it looks like most core portfolios lost money for the year while most non-traditional portfolios gained — many quite substantially.
Morningstar, Inc. data has the race a little closer than the eye suggests, stating that its nontraditional bond index gained .8% vs. the Barclay U.S. aggregate bond index’s loss of 1.6%. This isn’t too unusual. Since Morningstar created the nontraditional fund index, it has outperformed Barclays’s U.S. Aggregate in nine years and been beaten eight years. See: Top 10 alternatives to alternative investments for RIAs: 2013 edition.
Of course, not all unconstrained funds beat all core funds, and to further support their thesis, the authors claim that results for unconstrained funds “were highly random, with returns in the range of ±13%.”
Yet of the hundred-plus unconstrained funds represented on the chart, only one comes even close to that negative 13%. The next-worst performer was -4.5%, and the worst performer after that was around -2% — practically the mode for core portfolios in 2013.
Based on the year analyzed, it doesn’t seem as if freeing fixed-income portfolio managers to chase alpha where they best see fit actually leads to unpredictable, dangerous results. See: 13 for 2013: A baker’s dozen of issues you and your clients should really be focusing on this year.
Incidentally, that -13% fund, whose performance justified the article’s warning, appears to be the Credit Analysis Long/Short fund (FLSMX) was run by Cedar Ridge Partners until October of 2013 and is now managed by PIMCO for Forward Funds. Even with that one disastrous year, it has provided excellent returns since inception. And year-to-date, it has gained about 8% compared to 4.4% for Barclays U.S. Aggregate index and 2.25% for Morningstar’s nontraditional fund index. was managed entirely by
The article’s argument about unconstrained funds being riskier than core funds is more plausible. But again, those same charts do not support it very well. Most core portfolios have a standard deviation of between 2.5% and 4.5%, while it looks like the standard deviation for nontraditional bond funds was less concentrated in a range but usually fell between 2% and 6%.
That doesn’t seem like a major difference. The best conclusion I can draw from the chart is that because all unconstrained fund managers pursue different strategies, some are unsurprisingly more unpredictable than core portfolios but some are less. See: Top 10 alternatives to alternative investments for RIAs: 2013 edition.
Endemic corporate debt?
Another of the article’s conclusions was that nontraditional and unconstrained funds are heavily tilted towards high-yield corporate credit, which could be dangerous in “risk-off” years.
“We ultimately found considerable bias toward corporate credit both in terms of allocation and correlation within our universe. A significant portion of the universe maintains high and persistent exposures to credit and generates return streams that mimic those of high-yield and bank-loan strategies,” wrote Cohen and Lei, who continue:
“To be fair, this bias may reflect the evaluation period; corporate credit probably offered the best potential risk-reward tradeoff for an unconstrained investor over the past three years. However, if the corporate credit bias is perpetual, most unconstrained strategies are essentially credit funds in disguise. This is unfortunate, because the pitfalls around investing in this manner are clear: Corporate credit investing is asymmetric and in risk-off periods, losses will mount.”
This article was no doubt written months ago, and it now seems more likely that the perceived bias was indeed a result of the evaluation period. In the three years analyzed between August 2010 and August 2013, iShares High-Yield Corporate ETF had a total return of almost 30% while the Barclays US Aggregate index returned less than 10%. Given this, it would be notable if there wasn’t a bias towards corporate bonds over this time, and it therefore seems at least open to question whether unconstrained fund managers should be roundly reprimanded for being overexposed to the them. See: The deep dish on why Meredith Whitney was dead wrong on municipal bonds.
Pursuing a mandate
To see if an emphasis in corporate debt is endemic to unconstrained investing, I looked up current allocations of the 14 U.S.-centric taxable bond funds with “unconstrained” in their official name.
As it turns out, these funds are comprised of, on average, 25.7% corporate bonds. Morningstar’s nontraditional bond index currently has an average corporate bond allocation even lower, at just 15.1%, so the small sample is probably inflating corporate bond allocation rather than understating it. For reference, Vanguard’s Total Bond Market fund has 22% of its assets in corporate bonds.
Given these figures, it seems as though corporate exposure has been reduced in the past year when, as the author’s final chart, Chart 3, shows, most funds had between 25% and 65% of their assets invested in corporate bonds.
While possible, it doesn’t seem like investors should be overly worried that a corporate credit bias is “perpetual” in unconstrained bond funds. It seems at least as plausible that unconstrained managers were simply fulfilling their mandate to pursue the best-returning assets they could.
Cohen and Lei have done good work defining unconstrained funds and looking at their potential uses in a portfolio.
But as they themselves acknowledge, the “unconstrained” label describes hundreds of portfolio managers pursuing unique strategies across the entire fixed-income universe. General conclusions are fairly tough to draw from this data and then apply to the whole group. See: The ABCs of doing due diligence on fixed income annuities.
Considering Bill Gross’s unconstrained fund — or one of another hundred or so strategic bond funds — to beat miniscule coupons and looming interest rate hikes? Well, broad theses won’t get you to your ultimate decision whether to invest. You’ll have to cast away generalities to grapple with the risks and rewards of each unique strategy and each manager’s individual genius. See: Russell Investments sells for $2.7 billion and the new owner will flip its $250-billion asset manager — yet again.
Searching for greater yield through an unconstrained bond fund may in fact demand more risk — or at least demand greater faith in the bond manager. In other words, with so much discretion involved, you might want a Bill Gross at the helm.
No people referenced
Mentioned in this article:
Top Executive: Joe Mansueto
Investment Management Consultants Association
Top Executive: Sean Walters
Top Executive: Bill Morrissey
Share your thoughts and opinions with the author or other readers.