NEW YORK (Reuters) - With the Federal Reserve expected by many to begin increasing interest rates next month, investors will be looking to the managers of unconstrained bond funds for protection.
But figuring out what the managers of these “go anywhere funds” are doing can give investors whiplash: managers are allowed to buy whatever securities they want whenever they want, and have carte blanche to do such things as sell Treasury bonds short and stuff their portfolios with derivatives.
On top of that, the average unconstrained bond fund has 198 percent annual turnover, according to Lipper, meaning that the securities in the funds in March could have been completely swapped out by September.
Understanding the mechanics of these funds has gotten so difficult that even analysts at fund research shops Morningstar and Lipper can’t get a handle on what these portfolios are doing, analysts told Reuters.
“A lot of promises have been made about unconstrained fixed- income approaches and those promises have been a lot more powerful than the level of disclosure that the funds provide,” said Michael Herbst, an analyst at Chicago-based Morningstar.
Fund companies say that the whole reason investors choose their funds is because they don’t want to be bothered with the nuances of what the managers are doing.
“When you switch over to an unconstrained portfolio mandate you are lowering your interest rate risk, but taking on manager risk,” said Anne Walsh, assistant chief investment officer for fixed income at Guggenheim Investments and co-manager of the $3.6 billion Guggenheim Macro Opportunities Fund.
If the past few months are an indication, investors are right to be concerned. Nine of the 10 largest unconstrained bond funds underperformed the Barclays Aggregate Bond Index in the 12 months ending June 30, as managers bet wrong by positioning their portfolios for the Fed to raise rates last year, according to Lipper.
Unlike most “core” or intermediate-term bond portfolios, unconstrained bond funds can have long, short or negative duration. Duration is a measure of a bond’s sensitivity to interest rate fluctuations, and going shorter or negative duration is an investment strategy pursued when rates are expected to rise.
A negative duration bond strategy can give investors a way to profit from rising rates and lower bond prices by taking a “short” bond position through Treasuries and/or Eurodollar futures. Conversely, a negative-duration portfolio could underperform or even suffer losses if rates fall.
And if the Fed doesn’t raise rates, investors in funds including the Pimco Unconstrained Bond Fund, which had a negative duration of 0.68 years as of July 31, and the Putnam Diversified Income Fund, which had a negative duration of 1.54 years as of July 31, will likely be disappointed if bond prices rise.
A Putnam spokeswoman wrote in an e-mail that the company believes its Diversified Income Fund is well positioned for investors, given that traditional multi-sector bond funds expose investors to interest rate risk, while often underusing other areas of fixed income such as credit risk, prepayment risk and liquidity risk.
“There has been much frustration by investors relative to core bond funds because these unconstrained funds have been positioned for rising interest rates and we have only seen Treasuries rally,” said Marc Seidner, chief investment officer for non-traditional strategies and lead portfolio manager of the $7.9 billion Pimco Unconstrained Bond Fund.
As an example, the $20.4 billion Goldman Sachs Strategic Income Fund performed well during the “Taper Tantrum” of the summer of 2013, as it shorted Treasuries, thus having negative duration, and delivered a positive return of 1.47 percent. By year end, the fund’s total return was 6.43 percent.
The Goldman portfolio had a negative duration of 5.3 years at the end of July 2014. However, that same negative duration turned out to be a two-edged sword: In 2014, the fund was down 0.50 percent, a year that saw the 10-year Treasury yield fall from 3.029 on December 31, 2013, to 2.172 on December 31, 2014.
“It is not a timing product,” said Michael Swell, portfolio manager of the Goldman Sachs Strategic Income Fund. “We aren’t going to get it right all the time but our investment strategy is more right than wrong.”
As of June 30, the Goldman Sachs Strategic Income Fund had a positive duration of two years. As of the end of last month, Goldman Strategic Income’s duration was 0.75 years.
While many of these funds’ duration can swing wildly from one month to the next, not all of them disclose their holdings and their portfolios’ duration monthly.
Only 50 percent of funds in Morningstar’s “non-traditional bond fund” category, which includes unconstrained bond funds, reported their duration to the company every month.
For example, the Virtus Strategic Income Fund discloses its duration and holdings quarterly.
One example of how difficult it is to discern what is going on with these funds is with the $994 million Western Asset Total Return Bond Unconstrained Bond Fund, which held about 17 percent cash as of June 30, according to the firm. But until Reuters pointed it out, Morningstar’s data showed the fund had over 66 percent cash. Lipper showed that the fund held 90 percent in cash, but the company noted the fund was negative 75 percent in the “other” category.
The Western fund, which like many unconstrained bond funds uses future contracts and other derivatives widely, was not including the notional value of these contracts when determining the entire value of the portfolio, while Morningstar was including the negative exposure posed by these contracts, accounting for the discrepancy, said John Martin, a portfolio data specialist at Morningstar.
The problem is that every fund company discloses and values its derivatives differently, he said. “It’s a foggy area,” Martin said.
Western said it works with Morningstar and other data providers to make sure that the characteristics of its funds are accurately represented.
Morningstar changed the cash number for the Western Fund to 16 percent after Reuters discovered the discrepancy.
The U.S. Securities and Exchange Commission is working on a rule to standardize disclosure of how funds use derivatives.
Given the lack of transparency and the latitude that managers of these funds have, some advisers, like Josh Brown, chief executive officer of Ritholtz Wealth Management, are telling their clients to steer clear of these funds.
“Some of these funds will do well, and some won’t,” he said. “Based on the limited amount of knowledge about what they are doing, how can I possibly represent to my clients that I know which one is going to work?”
Reporting By Jessica Toonkel and Jennifer Ablan; Editing by John Pickering