Fidelity turns its nose up at unconstrained bond funds

Nontraditional bond funds could be the hottest investment product of the year, having grown faster than any other fixed-income category tracked by Morningstar Inc.
The category, which includes the popular benchmark-agnostic bond funds sometimes called “go-anywhere funds,” has grown by $43 billion over the 12-month period ended July 31. That compares with intermediate-term bonds, a core holding for many investors, which have lost $28 billion.
Those flows have boosted fund companies with “unconstrained” strategies, as they’re also called, including J.P. Morgan Asset Management, Goldman Sachs Asset Management and BlackRock Inc.
J.P. Morgan’s Strategic Income Opportunities Fund (JSOAX) is the firm’s most popular fund strategy this year through July 31. Goldman Sachs’ Strategic Income Fund (GSZAX) is also its highest-drawing offering, bringing 10 times the amount of flows of its second-most-popular fund, the MLP Energy Infrastructure Fund (GLPAX). And BlackRock’s Strategic Income Opportunities Portfolio (BASIX) saw inflows of $7.1 billion this year while their entire lineup took in $7.4 billion, according to Morningstar.
Given these heady numbers, one might think fund managers would be rushing to bring their versions to market. But some firms are sitting on the sidelines, including dominant players, such as The Vanguard Group Inc. and Fidelity Investments, which manage large fixed-income investment divisions but neither offers any funds whose manager — untethered by a benchmark — has the ability to traverse the bond markets in search of duration-risk reduction or absolute returns.
Instead, some are raising concerns about the products.
“We haven’t seen [the funds] to be consistent performers,” said Fidelity portfolio manager Robert Galusza, without naming specific funds.
“Some of these other alternatives, you may get return distributions that you didn’t anticipate and they’re not as well proven as the core strategies,” said Mr. Galusza, a nearly three-decade Fidelity veteran who manages nearly $13 billion in traditional bond strategies. “You may not be getting a clear message from the manager as to what their strategy is.”
Mr. Galusza argued that investing in traditional bond funds is a more predictable choice for investors.
“When you budget for risk, you know within a range what your expected outcomes are going to be,” he said. “We’re not catering to the new thing that we don’t know how it’s going to perform.”
The critiques aren’t new. Even fund managers who offer unconstrained products, such as former Fidelity manager Bill Eigen, who now runs J.P. Morgan’s benchmark-free bond strategy, have been critical of the credit risk taken on by the diverse funds.
But Mr. Galusza’s remarks draw into relief the distance the alternative products must go to gain mainstream acceptance. The funds can be difficult for advisers to fit into an overall risk budget for their portfolios, according to advisers and analysts.
That said, some advisers and fund managers say the products could be invaluable in the future, as rising U.S. interest rates erode some bonds’ value. Unconstrained managers are expected to steer clear of those risks.
Some analysts said the absence of large fund sponsors such as Fidelity from the market is no surprise.
Launching an effective unconstrained strategy is no easy feat, according to people with expertise in fund product development. Because the products invest widely — including in more esoteric securities like emerging-markets bonds — they require firms with deep research capabilities across geographic and credit markets, as well as an asset-allocating team to put the puzzle pieces together. That would make it difficult for small bond managers to gain traction.
For a fund to take off, a fund manager would need truly free rein to take bold bets.
“They would never let you do that at Fidelity,” said Barry Fennell, a former Fidelity fixed-income analyst who now works at Lipper Inc., the fund-manager research firm. He said the firm’s clients — particularly institutional clients such as retirement plan sponsors — are interested in shoehorning products into prescribed places within portfolios.
“It’s tough in the fixed-income world to market that product to folks who have a certain duration in mind or a certain credit quality in mind,” he said.
On top of that, the firm offers a successful “constrained” multisector fund — the Fidelity Strategic Income Fund (FSICX) — that might overlap and confuse investors.
Fidelity historically has been a stock-oriented shop, but the firm’s product teams have been actively expanding their fixed-income teams. They’ve also examined alternatives in recent years without launching new product in the area.
Fidelity’s taxable and municipal bond products won $2.3 billion this year from investors, Morningstar estimates. Firmwide, the company’s funds have lost a total of nearly $8.6 billion, although some of those flows have been to other investment products.
In a statement, Fidelity said its fund lineup has “excellent breadth” for bond investors.
As for performance of unconstrained bonds, the jury is out.
A Lipper category that includes unconstrained funds is up 4% over the 12-month period ended June 30, 3.5% over three years and nearly 7% over five years. That compares with 4.9%, nearly 4% and nearly 5.9% for core bond funds over the same periods. But an important caveat is the returns of the products vary widely, many are designed to perform best in the future, when rates rise, and many did not exist five years ago.