How much should you allocate to nontraditional bonds?

Just because the mutual fund industry has been flooding the market with nontraditional bond funds is no reason to jump blindly into the space, according to Eric Jacobson, senior fund analyst and co-head of fixed income at Morningstar Inc.
Citing a 36% average weighting in junk bonds across the nontraditional bond fund universe, Mr. Jacobson emphasized the reality that portfolio managers sometimes go to extremes to stand out in an increasingly crowded space.
“Having 36% in high-yield bonds doesn’t put these funds in the high-yield space yet, but it is a pretty big allocation,” he said Tuesday in Boston at the Investment Management Consultants Association annual conference.
He explained that a fund would need a 65% allocation to high-yield to be considered a high-yield category fund, but added that at 36%, some of the non-traditional funds could be re-categorized as multisector funds.
Morningstar currently has six subcategories in the nontraditional bond fund universe, but Mr. Jacobson said funds are placed in categories based on how they actually invest rather than what the prospectus says or fund name might suggest.
The nontraditional bond fund universe has grown rapidly, primarily due to the looming threat of higher interest rates, which could be devastating to traditional bond portfolios that could see bond prices fall in relation to rising yields.
Morningstar now tracks more than 70 nontraditional bond funds, up from just 15 in 2008. Total assets in those funds has reached more than $120 billion, up from $15 billion in 2008.
But while fund companies have rolled out products and investors have moved in, Mr. Jacobson points out that, thus far, the funds have not completely delivered. So far this year, the average return for nontraditional bond funds was 1.6%, which compares with a 2.9% gain for traditional intermediate-term bond funds.
The three-year average return for nontraditional funds was 2.5%, compared with 3.7% for intermediate-term bond funds. The three-year performance includes the brutal period of 2011 when nontraditional funds averaged a 1.3% decline, compared with a 5.9% gain for intermediate-term funds.
Over the five-year period, which includes a smaller number of nontraditional funds, the category averaged 6.7%, compared with 6.4% for intermediate-term bonds.
But even if performance was closer to that of traditional strategies, Mr. Jacobson points out that the fee disparity is difficult to justify.
The mean average expense ratio for nontraditional bond funds is 0.99%, or 77% higher than the average expense ratio for intermediate-term funds. On a weighted-average basis, the expense ratio for nontraditional funds, at 0.77%, is 88% higher than intermediate-term bond funds.
“I know the fund companies are thinking of it as these are hedge fund-like strategies and they want to argue that you should be willing to pay more for better products,” Mr. Jacobson said. “But you have to believe that internally the discussions are all about leveraging the existing resources, so you should take their argument about fees with a grain of salt.”