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

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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.

Jingwei Lei questions the promise of unconstrained bond funds.
Jingwei Lei questions the promise of
unconstrained bond funds.

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.)

Chart 1: Unconstrained funds risk vs. reward
Chart 1: Unconstrained funds risk vs.
reward

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%.”

Chasing alpha

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

Chart 2: Core bond fund risk vs. reward
Chart 2: Core bond fund risk
vs. reward

Surprising deviations

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.

Chart 3: Corporate exposure and correlation in unconstrained funds
Chart 3: Corporate exposure and correlation
in unconstrained funds

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.

Generalities aside

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:

Morningstar, Inc.
TAMP
Top Executive: Joe Mansueto

Investment Management Consultants Association
Association
Top Executive: Sean Walters

LPL Financial
Asset Custodian
Top Executive: Bill Morrissey



Share your thoughts and opinions with the author or other readers.

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Jim Phillips said:

October 13, 2014 — 8:02 PM UTC

This may be a good example of the classic story of the three blind men describing an elephant. Not only are the category definitions a bit loose, but we are at a point in the interest rate and economic cycles where it may be particularly problematic to use the rear view mirror to formulate a current course of action.

We don’t invest in categories. We make informed decisions about investing in specific funds. There is so much variance between these flexible bond funds that the decision should always be one of evaluating its suitability for a particular application.

In general, investors should understand the full range of risk and potential return characteristics of a fund before going in. If a fund’s portfolio or strategy is too opaque or complicated to understand, it may be better to look elsewhere.

Because we are likely near an inflection point in the rate cycle, investors evaluating their PIMCO Total Return positions have more than Bill Gross to thing about. Do they want to maintain that degree of exposure (at PIMCO or elsewhere) or do they want to reduce the level of risk in the “safe” end of their portfolios?

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brooke southall said:

October 13, 2014 — 8:20 PM UTC

Jim,

I accept your criticism with all the dignity possible of an elephant molester.

Brooke

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Jim Phillips said:

October 13, 2014 — 9:50 PM UTC

LOL Brooke. What you’re doing with that bag of peanuts is a private matter.

On a more serious note, I think you do a superb job of gathering useful information and making it accessible. It’s hard to find time to stay current on all that is going on in our interesting corner of the investment world, and your site is both useful and interesting.

As this article illustrates, there are multiple perspectives on most investment topics and that makes for a healthy market.

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Brent Burns said:

October 13, 2014 — 10:06 PM UTC

One’s perspective on unconstrained bond funds hinges on one’s opinion on bond funds and the role of fixed income in a portfolio. I think that bond funds have embedded risk in a rising rate environment. Unconstrained bond fund try to mitigate that risk by giving greater flexibility, including the ability to go short. The problem is that the bond market doesn’t always do what you think it will do when you think it will do it. Bill Gross can testify to that on his call to short Treasuries just before S&P downgraded US debt. Should have worked, but it didn’t. And investors paid the price.

I view bonds as an investor’s safe money. And for those in retirement, we use them to generate a predictable paycheck using individual bonds. Why individual bonds? Because individual bonds are a unique security…a legal obligation by the issuer to pay back the investor his or her principal with interest. The exact amount and timing of those payments are known in advance, so individual bonds are predictable. And each investor can buy bonds to match his or her cash flow needs buy matching up maturities. When interest rates rise, neither the principal nor the interest are affected so long as the investor holds the bond to maturity. Thus the downside is limited to the YTM on the bond the day it is purchased (assuming high quality bonds like government agency bonds). And YTM is positive.

Bond funds, on the other hand, are simply mutual funds that happen to invest in bonds. A fund does not have a legal obligation to pay principal and interest. The turnover within a fund means that many bonds are not held to maturity and thus losses caused by rising rates are realized within the NAV. An investor needing to take systematic withdrawals can lose principal when rates rise, unlike individual bonds set to mature when the investor needs cash.

Unconstrained bond funds seek to give more flexibility, especially around duration, so that if rates rise, the fund won’t be a sitting duck. Unconstrained managers are given greater freedom to take bets, but the timing often doesn’t pay off. For investors taking systematic withdrawals, any missed timing creates sequence risk (think worst case reverse dollar cost averaging). Returns within an unconstrained fund come more from the managers bets paying off than the natural, stable nature of the underlying bonds. Figure 2 above highlights the range of returns and ST DEV for a given asset class. That kind of dispersion makes taking withdrawals more like a roulette game than a paycheck. Although lower relative volatility and low correlation might reduce overall portfolio volatility, volatility to the downside for anyone taking withdrawals means that retirees will be drawing out of a portfolio that has less money and therefore less money to recover.

I do not see fixed income as the place to take risk in a portfolio and thus don’t see a role for unconstrained bond funds. I see the role of bonds, specifically individual bonds, not bond funds, as the portion of a portfolio that should stand strong when the rest of the portfolio is under pressure. Consider 2008. When your equity portfolio is seeing huge declines you don’t want your bond fund also declining because it is overweight lower investment grade corporate bonds or has negative duration in anticipation of rising rates. Neither of those bets would have payed off, but an agency bond maturing at the end of ’08 matured on schedule so the investor wasn’t forced to sell into a declining market that was losing liquidity.

You don’t hold bonds for the markets we have seen since ’09. You hold them for markets like ’08, 2000-02, 1973-74. And especially for markets like 1969 when both stocks and bonds were down. Unconstrained bond funds just add another risk factor to bond funds, which are already risky enough in a sustained rising rate environment. I would gladly give up the chance at alpha (which any SPIVA scorecard will show is challenging enough) for the predictability and certainty of individual bonds when markets are falling apart (or the manager guessed wrong). I’ll take my risk on the equity side where investors are better compensated for taking on uncertainty.

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Jim Phillips said:

October 14, 2014 — 2:03 PM UTC

Very well put. Over 90% of our business is DC plans, where individual bonds are not available, so we are particularly sensitive to bond fund selection for our plan menus, taking into consideration the plan demographics and our capital market expectations. Bond fund selection is no less complicated than selecting stock funds, although I’m not sure how many people appreciate that.

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brooke southall said:

October 14, 2014 — 3:18 PM UTC

Jim,

Thank you for your kind comments about RIABiz and I agree with you about Brent’s comment. In fact I’m trying to convince him to add a few things and we’ll run it as a column.

BTW, I like the elevator pitch on your site and the fact you even call it that…on your site. It has some plainspoken language and an air of humility.

.”.more of your employees will retire with greater security than would otherwise be the case….you will sleep better at night knowing that your retirement plan is in good hands and in good shape.

Brooke

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Jim Phillips said:

October 14, 2014 — 4:45 PM UTC

Thanks Brooke. Our success is largely attributable to transparency, clear communication, and commitment to making a difference. Pretty straightforward, yet it seems to differentiate us…

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FAA said:

October 14, 2014 — 8:48 PM UTC

Three comments:

1. Unconstrained bond strategies are just that unconstrained and able to invest where the manager identifies the best risk reward profile coupled with the ability of the manager to execute. Managers will have differing views on risk/reward and different capabilities to execute hence the wide dispersion of performance within the category. Simply put some managers might have better corporate credit resources, some emerging market, currency etc. Utilizing historical data to assess the veracity of such strategies is inadequate at best and perhaps misleading. Really should have a qualitative assessment of the strategy – sitting down with manager(s) to understand what they do, where they go and how they do it to get a real sense.

2. In theory, the comments about buying individual bonds makes sense- in practice it is much harder for average investors or advisors. The bond market is an auction where size is your friend- believing you can get similar execution trading 25,000/50,000/100,000 lots as Blackrock is not gonna happen. Further- you have no idea regarding implementation shortfall. Also- assuming you buy individual credits- taxable or tax exempt- you really do need a robust research group particularly today. Finally- how do you benchmark your activity? Is there a GIPS compliant or audited track record to point to? While it sounds good…as does an unconstrained bond strategy ironically…the devil is in the details.

3. I do agree that assessing bond funds is more difficult than one might expect- particularly anything related to any form of credit. Another reason why you should have a qualitative evaluation rather than rely on quantitative/ statistical only.

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Brent Burns said:

October 16, 2014 — 3:55 AM UTC

FAA, although still behind the equity markets in terms of liquidity, the newer ATS systems like Tradeweb Direct have really compressed the bid/ask spreads. When building out a portfolio of individual bonds, we look to match the spending needs for those in retirement (those in accumulation are a little different). Think paycheck portfolio. We aren’t trying to generate total return. We are matching cash flows using a liability driven (LDI) approach. Thus, the target cash flows are the benchmark. Actually LDI is a special case total return where the downside is limited to the YTM on the bonds, but upside can be realized if the gains worth recognizing when rates fall. The purpose of the portfolio, however, is to manage sequence on both the equity and bond portfolios.

By holding bonds to maturity, interest rate risk can be eliminated and by matching the timing of the maturities to the cash flows, shortfall risk is eliminated. Credit risk is usually not rewarded in an LDI scenario, so we tend to stick with CDs and Agency bonds unless munis are warranted. Munis require a lot more diligence and monitoring, but the tax benefit can be worth the extra effort.

A goals-based/LDI approach also changes the bond allocation conversation from a nebulous percentage to a concrete time horizon, say 8 years. Thus, the portfolio would generate 8 years of predictable income, which provides a time buffer to ride out poor equity market conditions and give the portfolio time to recover.

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FAA said:

October 16, 2014 — 1:33 PM UTC

Brent Burns- so effectively you are dedicating the bond portfolio vs anticipated cash flow needs right? Have some background in this and this approach was a popular strategy for pension liabilities/ insurance contracts (GICS) when the yield curve was inverted and rates were high- obviously the discount function on the liabilities had a lot to do with that. LDI is really a reiteration of what was done in the ’80’s/90’s. So I think I get what you are doing and seems reasonable to me-two points I might add. Dedicated bond portfolios tend to be more expensive than immunized bond portfolios- match duration, skewness and minimize month squared deviation. Not to say your approach doesn’t work just an observation. Secondly- you still have to trade it in odd lots I would imagine. That’s the tough part- but good for you folks if you can work through that.


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