Morningstar warns about 'gimmickry' in unconstrained bond funds

No doubt about it, unconstrained bond funds are hot right now. But according to Eric Jacobson, director of fixed-income research at Morningstar Inc., financial advisers need to be wary of these relatively new breed of funds. Managers of unconstrained bond funds can buy any type of debt instrument — both within the U.S. and abroad. A number of fund managers have launched such funds in the past several months to provide investors with fixed-income options that won't necessarily get killed — if and when interest rates rise. “Already, we are seeing a number of garden variety bond funds morphing a bit,” Mr. Jacobson told attendees yesterday at Morningstar's annual investment conference in Chicago. “But it's a very difficult transition.” One of the challenges is that many of these funds are making bets on emerging markets, which carry greater risk, Mr. Jacobson said. In general, advisers need to watch out for “gimmickry,” he said. While a lot of reputable managers, such as Pacific Investment Management Co. LLC, BlackRock Inc. and J.P. Morgan Asset Management have gotten into this space, Mr. Jacobson said he is worried some investors may not know what they are getting into. “I am not suggesting that there is bad intent on the part of the managers,” Mr. Jacobson told InvestmentNews after his panel discussion. “But a lot of investors are hoping and expecting that when the time comes, [these funds] will save them from all of the pain,” he said. Many of these funds are using Libor or the three-year Treasury bill as a benchmark, which aren't a great gauge because they are “riskless benchmarks,” Mr. Jacobson said. If advisers do find managers that they believe in, he warned that they proceed with caution. “You need to be really careful,” Mr. Jacobson said. “At most, use them peripherally.”