“Unconstrained” fund managers used by advisers to avoid hazards in bond investing are increasingly moving in tandem with some of the market's most volatile bets.
The products go by a variety of names — unconstrained, go-anywhere, strategic, flexible, alternative, or nontraditional — and they include managers employing a variety of strategies. The funds can deviate from benchmarks that would otherwise constrain their manager's choices, say by requiring a certain level of allocation to U.S. Treasury debt. And they're pitched as a risk minimizer anticipating the bogeyman of rising interest rates.
Yet the trajectories between unconstrained funds and notoriously volatile asset classes like stocks and high-yield bonds has been on the rise, according to Lipper Inc. That correlation may be troubling for advisers who have been shifting billions of dollars from less-correlated bond funds to the alternative strategies.
“High yield has been running hot, and so some of these funds — not all of them — but some of them have gravitated to higher exposures to high yield,” said Greg Silberman, chief investment officer at Atlanta Capital Group, a registered investment adviser with $1 billion in client assets. “They're just going to get hurt by the selloff in high yield; it's as straightforward as that.”
Mr. Silberman's bearish view of the category's short-term prospects and exposure to junk bonds is mirrored by Bill Eigen, who runs the world's largest unconstrained strategy, the nearly $26.9 billion J.P. Morgan Strategic Income Opportunities Fund (JSOAX). After profiting from his fund's exposure to high yield debt, his fund has been working to shift to cash and other, more complex, hedges against market movements, according to statements by Mr. Eigen and his colleagues.
“A lot of these strategies — to maintain an attractive yield — have been stretching to take on more equity risk,” said Oksana Aronov, a fixed-income market strategist at J.P. Morgan Asset Management. “You have to recognize the best time to get out of a sector you've exploited — when you've gotten the most out of it — and that's what we've done in the last year.”
The J.P. Morgan fund's rolling 50-week correlation to high yield is still high compared to some competitors, 0.8 at the end of July, but that trailing indicator is down from 0.92 at the end of March, according to Lipper. A correlation of 1 indicates that returns between the two assets moved exactly together over the time period, while a correlation of 0 indicates no relationship. Over the 12-month period ending in July, the fund has been beaten by 66% of its peers, while it's in the 39th percentile over the three-year period and 56th over five, according to Morningstar Inc.
Ms. Aronov said competitors have been rewarded for their complacency and reliance on concentrated exposures in a low-volatility market.
An unconstrained quest for yield
http://www.investmentnews.com/wp-content/uploads/assets/graphics src="/wp-content/uploads2014/08/CI95915812.JPG"
Data point: Rolling 50-week correlations of unconstrained bond funds to high-yield bond funds and multi-cap core stock funds for the 56 weeks ended Aug. 1. A correlation of 1 indicates that returns between the two assets move exactly together, while a correlation of 0 indicates no relationship. Source: Lipper.
Naturally, past correlations don't anticipate what managers will do next. And the diversity of unconstrained strategies is vast.
Because managers can change strategies at will, it is increasingly difficult for advisers to judge the risk exposures of their clients' portfolios, according to Jeff Schwartz, president of Markov Processes International, a research firm. He said he worries that advisers are underestimating the hedge-fund like diversity of the category and “unintentionally exposing your client to more or less risk than you imagine.”
“By giving full control of the fixed-income portfolio to these managers or a combination — what it means is losing control a bit of the overall portfolio,” Mr. Schwartz said. “The issue is you've seen from our analysis the huge deviations from one manager to another — to go from the JP Morgan Strategic Income to the Goldman Sachs Strategic Income [GSZAX] is not like going from large growth manager A to large growth manager B — these are different animals.” (Goldman Sachs Asset Management declined to comment.)
One thing the funds do share is their popularity. Last month, they took in $3.6 billion. Over the last year, the figure is nearly $53 billion, according to Lipper.
That comes as the funds they've increasingly track — high-yield — have been deflated by withdrawals. After building their exposures to high-yielding debt for most of the year, investors moved $12.6 billion out of those funds in the four-week period ending last Friday, Lipper said. The week included the largest single-day retail outflow ever from the funds, according to Bank of America Merrill Lynch.
Many expect the popularity of the products to continue. Despite what he sees a short-term risks, Mr. Silberman thinks many of the funds are likely to meet the objective of navigating a rising-rate environment. The Federal Reserve is expected to raise interest rates it controls in 2015, which could erode some bond returns.
“Advisers have a lot of products, they have to make a lot of decisions, they didn't necessarily want to make a duration and a credit decision and go through and talk to the clients and execute all those tickets,” said Peter Hayes, who leads municipal bond portfolio management, research and trading for BlackRock Inc., the world's largest money manager. He also runs a “flexible mandate” strategy, the nearly $1.7 billion Strategic Municipal Opportunities Fund (MEMTX). “They really want the money manager to make the decision for them in a one-stop type of fund.”
