Stocks popping up in more bond portfolios as managers seek returns

At least 70 mutual funds across various fixed-income categories have more than 4% allocated to stocks, according to Morningstar

May 9, 2014 @ 12:01 am

By Jeff Benjamin

If you're investing in a bond mutual fund that has been generating outsized returns over the past few years, chances are it's less of a bond fund than you might have thought.

According to the most recent portfolio data tracked by Morningstar Inc., at least 70 mutual funds across various fixed-income categories have more than 4% allocated to stocks. On the extreme end, almost half of those bond funds have equity weightings of between 10% and 63.4%.

“A lot of equity inside a bond fund should raise a red flag that management is not able to find good investment ideas in his or her primary area of focus,” said Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ.

“Given how strong stocks were in 2013, when the S&P gained 30%, any bond fund holding stocks will have augmented returns,” he added. “The caveat is that stocks offer higher returns because they are riskier.”

As bond yields have hovered near historic lows, more bond fund managers have been turning to stock allocations for extra performance as part of a little-discussed trend that has the potential to end badly.

In some cases, the bond funds are designed to be flexible with nontraditional and multi-sector bond mandates, but for an adviser or investor who might be constructing portfolios based on broad categories, there could be some rude awakenings.

For example, the Eaton Vance Bond Fund (EVBAX), grouped in Morningstar's multisector bond category, had a 17.6% weighting in stocks at the end of February. The upside of all that equity-market exposure is that the fund is up more than 5% from the start of the year, which compares to a multisector bond category average of 3.5%, and a Barclays U.S. Aggregate Bond Index gain of 3.2%.

Of course, loading up on stocks doesn't always translate to outsized performance.

The Spectrum Low Volatility Investor Fund (SVARX) and the Compass EMP Market Neutral Income Fund (CBHAX), are both in the nontraditional bond fund category and have 27.5% and 63.4%, respectively, allocated to stocks. The Spectrum fund has gained just 1.9% this year, while the Compass fund gained 1.5%.


“I see a lot of weird things in fixed income right now, including managers allocating more to equities,” said William Eigen III, manager of the JPMorgan Strategic Income Opportunities Fund (JSOAX). Mr. Eigen's fund is a nontraditional bond fund that could hold equities but he doesn't believe that is his role.

“The decision to go into equities isn't mine, it's yours,” he said, suggesting that investors don't usually buy a bond fund for equity exposure.

David Young, founder and chief executive of Anfield Capital Management, put at least part of the responsibility on Morningstar for not putting funds in the proper categories.

“We know Morningstar categories are not perfect,” he said. “But between the category imprecision and the manager drift, it is the oldest game in town to try and game the categories” by using stocks to add performance in a bond fund category.

Eric Jacobson, a senior fund analyst and co-head of fixed income at Morningstar, said funds are placed in categories based on “what they do, not on what the prospectus says.”

Mr. Young not only doesn't have a big problem with the migration into bonds, his own Anfield Universal Fixed Income Fund (AFLIX) is at least marginally guilty of the practice.

The fund, which Morningstar puts in the high-yield bond category, has a 0.03% allocation to equities.

“There's only so much you can do with fixed income right now, and some managers choose to include some equities,” he said. “This is all part of the rise of the unconstrained bond strategy and that's what we do. You don't want your bond manager to just stand on the train tracks and wait to get run over while focusing on a benchmark.”

Whether it is an evolution within the bond fund space or temporary performance chasing, the onus is on advisers to peer closely under the hood of bond funds.


“The only reason to put equities into a bond fund is to juice returns, because it isn't being done to reduce risk,” said Aaron Izenstark, chief investment officer at Iron Financial. “If you've got stocks in a bond portfolio over the past year, you look great, but if you don't look inside the fund you might not realize what's going on.”

“If there's a sudden stock market drop, you could have real problems,” he said.

The potential problems, which will depend on how much a bond fund has migrated into the equity space, begin with not providing the level of fixed-income exposure an investor might be banking on to help ride out some choppy markets.

“It definitely adds risk to a bond fund to include equities,” said Jeff Tjornehoj, head of Americas research at Lipper Inc. “A bond portfolio with 10% in equities won't have comparable volatility of a fund with no equities. And that can lead to wild performance relative to its peers.”


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