Successful go-anywhere bond funds kept bets in check – but was performance due to skill or luck?

A new analysis of a popular group of funds designed for rising interest rates reveals clues as to why those funds haven’t kept up with the broader bond market.
So-called go-anywhere bond funds with the weakest performance over the last two years appear to have failed to time their exposures to currencies and credit effectively, and were also poorly positioned for interest rates that fell when managers thought they’d rise, according to an analysis by Markov Processes International Inc., which provides data-integration, portfolio-analysis and reporting software.
But the new study suggests that advisers who flee the category too quickly may miss out on the benefits of funds that are delivering superior performance. Funds at the top of the returns chart appeared to time many of the same exposures effectively.
$5 BILLION IN OUTFLOWS
This year through Aug. 31, go-anywhere bond funds have lost $5 billion to outflows, although the flows would have been positive if not for three large funds from Pacific Investment Management Co., J.P. Morgan Asset Management and Goldman Sachs Asset Management.
Without the outflows from those three funds, the category, sometimes called unconstrained or strategic income, would be up $8 billion. A total of $147 billion was invested in the funds as of August, according to Morningstar Inc.
“Nontraditional bond is a swamp filled with a lot of beauty and a lot of wonderful things, but it’s got danger lurking beneath the surface,” said Jeff Schwartz, president of Markov Processes International (MPI). “We don’t think a lot of people invested in these products know how to benchmark them.”
MPI examined the returns of the nontraditional bond fund category tracked by Morningstar and attempted to isolate the performance that came from managers doing a good job at timing their market exposures and security selection and those that didn’t from Aug. 26, 2013, to Aug. 21 this year.
On average, the top five funds in the category effectively timed their exposure to credit, bank loans and foreign currencies. For instance, the successful funds appeared to trim exposure to high-yield funds and bank loans starting after mid-2014, before those assets lost some steam. And while the average fund in the category shows returns consistent with a net short position on Treasuries, the top funds were less dramatically short.
During the period of the study, yields on 10-year Treasury notes fell to 2.04% from roughly 2.79%. Bond prices move inversely to yields, so shorting that asset class generally didn’t help fund managers to boost returns.
BIG DISPERSION
“Any time you have a strategy that has a lot of latitude … you’re going to have big dispersion between winners and losers betting on different things,” said Jason Kephart, ‎an alternative funds analyst at Morningstar. “A big question is: Just because you were right over the last two years, does that mean you’re going to be right over the next two? I wouldn’t be surprised if you saw the top five and the bottom five flip.”
In May, DoubleLine Capital founder Jeffrey Gundlach warned that investors in unconstrained bond funds “will be surprised that they are actually doing worse in many of these funds in 2015” than in index funds. So far, he’s been right. The modestly negative -0.05% return of the category, through Wednesday, is lagging the 0.66% return of the Barclays U.S. Aggregate Bond Index, according to Morningstar. A widely used set of traditional bond funds, grouped as intermediate-term funds, have gained 0.27% this year.
MPI’s analysis works, in part, by comparing the funds’ returns with a variety of fixed-income benchmarks, but the full methodology is a house secret. And quantitative attribution analyses aren’t perfect.
In a disclaimer, MPI says that it “does not claim to know or insinuate what the actual strategy, positions or holdings of the funds discussed are, nor are we commenting on the quality or merits of the strategies.”
Dieter T. Scherer Jr. , a financial adviser at Adaptive Wealth Solutions in Chester, Md., said that it may be more instructive to understand why managers made the decisions they made rather than what the decisions were specifically. He said attractive funds may have done poorly due to bad luck, rather than a bad process. And he stressed that styles that did well during the recent past may not be rewarded in the future.
“I’d say nontraditional fixed income strategies are likely to offer a smoother ride over the next few years — the trouble, as always, is in finding the ones that are worth utilizing,” said Mr. Scherer. “When considering a manager, the most important aspect is the process the manager follows.
“Systematic investing processes allow you to better judge how the manager may do in the future,” he said. “When a process is systematic, it’s reproducible and testable across a variety of market environments.”
MPI argues that quantitative factor analyses of funds can say more about returns that simply looking at periodically produced lists of the securities that the funds hold.
‘MASSIVELY DIVERSE CATEGORY’
“You’ve got this massively diverse category filled with a lot of products that are really like hedge funds and lot of these products have hundreds and hundreds of positions, including derivatives, futures and options,” said Mr. Schwartz. “The positions are just unbelievably hard to understand.”
The top funds used in the analysis were Semper MBS Total Return (SEMMX), Legg Mason BW Alternative Credit (LMAMX), Voya Strategic Income Opportunities (ISIAX), Guggenheim Macro Opportunities (GIOAX) and Pimco Mortgage Opportunities Fund (PMZAX).
The bottom funds, starting from last, were the BlackRock Allocation Target Shares Series Portfolio (BATPX), the Fortress Long/Short Credit Fund (LPLAX), Highland Opportunistic Credit Fund (HNRZX), Driehaus Select Credit Fund (DRSLX) and the UBS Fixed Income Opportunities Fund (FNOAX).
“UBS Fixed Income Opportunities Fund aims to deliver strong risk-adjusted returns that are uncorrelated to both traditional fixed income assets and interest rates over the course of a full business cycle. It is different from many other funds in Morningstar’s nontraditional bond category in that the fund is more tactical, less beta-biased and utilizes greater duration flexibility,” UBS spokesman Gregg Rosenberg said in an emailed statement. “In a period where spreads widen and rates rise, we would anticipate funds with higher correlations to credit and limited duration flexibility (i.e., top 5) to underperform.”
A spokesman for the Fortress fund, David Ferreira, said that the manager and strategy of the fund has changed during the time period.
Highland Capital Management declined to comment.
“For duration-neutral strategies like ours, which always holds an interest-rate hedge, we would expect to see the hedge detract from performance as rates decline, much like the analysis highlights,” said K.C. Nelson, portfolio manager for the Driehaus fund, in an emailed statement. “Our clients understand that positioning, and it is one of the primary characteristics that are sought by them when they hire us.”
A look at the funds’ stated purposes may reveal more than their classification as a nontraditional bond fund. It’s no surprise, for instance, how the BlackRock Inc. fund performed. The prospectus’ description of the objective of the fund, which is available only in separately managed accounts, is to have a duration that’s the opposite of the Barclays U.S. Treasury 7-10 Year Bond Index.

Related Topics: BlackRock Inc., ING Group, JPMorgan Chase & Co., Legg Mason Inc., Morningstar Inc., Pacific Investment Management Company (Pimco), UBS AG