Dan Fuss: Risk in geopolitics, high-yield, leveraged funds

Bond fund manager Dan Fuss says the combination of increased global political risks and the potential for runs on bond funds — and leveraged bond ETFs — are making his firm “as cautious as we’ve ever been.”
“My number one concern is something happens that gets the money going out,” he said in an interview with InvestmentNews Monday. “The mischief maker would be the levered ETFs because you can just say ‘sell’ and the first seller gets their money, the second seller gets their money, the third seller sort of gets their money and kaboom, and you could have a run.”
Mr. Fuss vice-chairman and portfolio manager at Loomis Sayles & Co., which manages $221.3 billion.
His comments come as leveraged exchange-traded funds and related products that use derivatives to enhance their exposure to market swings have come under scrutiny.
Laurence D. Fink, chief executive officer of BlackRock Inc., the world’s largest money manager, in May said the funds had the potential to “blow up” the industry.
Mr. Fuss said a run could also affect open-end mutual funds focused primarily on high-yield or emerging-market debt “because the secondary market wouldn’t be there” as the relatively illiquid market for those bonds fails to keep up with demand.
“Will that ever happen? I hope not,” he added.
A run-up in bond funds offering yield-starved investors the prospect of higher returns has started to reverse. Investors pulled $2 billion out of high-yield funds in the two weeks ended July 23, according to Lipper Inc. That comes after investors poured about $5 billion into the funds over the last year.
Fund providers that offer geared ETFs, as the leveraged products are also known, said leverage is a common financial tactic that can allow investors to express a view on the direction of the market or hedge a position.
The firms — including Direxion, ProShares and VelocityShares — have said the products, which can deviate dramatically from their benchmarks over periods longer than a day, are not promoted as or intended for use as buy-and-hold investments.
“In the ETF space leverage is a tool and I think there’s a good use of leverage today,” said Mark W. Yusko, chief executive of Morgan Creek Capital Management, a fund manager that uses the products, speaking to InvestmentNews‘ ETF Exchange last month.
Many top-broker dealers have been fined for selling the products and now place strict limits on their sale.
Mr. Fuss said a possibly deteriorating political situation globally could light a fuse that would be difficult for the bond market to handle, in part because of the liquidity of underlying securities and because the leveraged ETFs are now a larger part of the market.
The fund category assets now total $42.9 billion, with about a fifth of that invested in bond markets, according to ETF.com.
Mr. Fuss did say that some political issues are overstated. While Argentina is at risk of defaulting on its debt obligations to foreign creditors, the impact of it doing so would be fairly isolated, he said.
Still, more worrying issues are brewing, he said, citing China’s military assertiveness in the South and East China Seas, ongoing violence in the Levant, and Western relations with Russia increasingly at loggerheads.
China’s Ministry of National Defense this week started military drills near disputed territories in the South and East China Sea. Israel continued to step up three weeks of strikes in the Gaza Strip.
And fighting continued Tuesday in Ukraine as the European Union agreed to wider sanctions on Russia, whose President Vladimir Putin is seen as crucial to ending clashes between the Kiev-based government and separatists in the country’s east.
“You put the two sides together — valuation and risk,” said Mr. Fuss, whose funds are building up reserves in short-term instruments. “Valuations are far more expensive than what they used to be and return, in yield terms, is far less than it used to be. And geopolitical risk is far higher than it used to be. That’s not good.”