Investors flee nontraditional bond funds at the worst possible time

Untested category suffers $4B in net outflows this year as it is about to be tested by higher rates.

As the Federal Reserve inches ever closer to its first interest rate increase since June 2006, investors have started shunning the one strategy designed to hedge the risks to fixed income in a rising-rate environment.
Nontraditional bond mutual funds, which have tripled in size since 2010 to more than $150 billion in 124 funds, have experienced $4 billion worth of net outflows since the start of the year. That comes on the heels of $22.7 billion of net inflows into the category last year, and $55.7 billion in 2013.
Even though these relatively new go-anywhere bond fund strategies were promoted and sold as ideal tools for hedging the interest-rate and credit risk inside a larger bond allocation, investors appear to be losing patience at the worst time.
While there has been wide disparity among the performance of the various funds, which can and will do different things at different points of credit and rate cycles, the category average as tracked by Morningstar Inc. is up just 71 basis points since the start of the year. Over the past 12 months, it’s down 17 basis points.
Meanwhile, the long-government bond category is up 6.5%, preferred-stock funds are up 4.6%, long-term bond funds are up 3.4% and bank loan funds are up 1.3% over the past 12 months.
‘FAIRLY LOUSY’ RETURNS
“The returns for nontrational bond funds have been fairly lousy, and people are starting to find out just how much they were sacrificing in terms of performance,” said Russel Kinnel, Morningstar’s director of mutual fund research.
“People are just losing patience with those strategies,” he added. “The problem is, now we’re coming to the time period which in theory is when you would want to own one of those funds.”
The asset management industry, which launched 33 nontraditional bond funds last year and has already launched a dozen such funds this year, isn’t giving up on the strategy even if investors are starting to lose faith.
Just this week, Franklin Templeton Investments tossed its hat into the ring with the Franklin Flexible Alpha Fund (FABFX).
A couple of other newcomers include the $26 million Sentinel Unconstrained Bond Fund (SUBAX) and the $35 million T. Rowe Global Unconstrained Bond Fund (RPIEX), both of which opened in January.
For any company already managing bond funds, rolling out a fund with an unconstrained mandate makes perfect marketing sense, according to Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ.
“An unconstrained fund can play in the space of rising rates, they can short bonds, go negative duration or hedge out rate risk as rates move up, and fund companies are launching these funds to diversify their businesses to incorporate strategies that can participate as rates start to go up,” he said. “Now is a more logical time to invest in these strategies, because as we get closer to the Fed raising rates, investors should want to have strategies that can go in multiple directions.”
Like most alternative-strategy mutual fund products, nontraditional bond funds are not easy to categorize, which leads to wide performance disparity, another frustration for investors.
PERFORMANCE VARIES WIDELY
So far this year, for example, returns in the category range from an 8.2% gain for the $30.5 million Parametric Absolute Return Investor Fund (EOAAX) to a 4.6% decline for the $49.5 million Cedar Ridge Unconstrained Credit Fund (CRUPX).
“The performance is very mixed because it’s a little bit of a kitchen-sink approach to the strategies,” said Michael DePalma, director of fixed-income absolute return at AllianceBernstein.
“My contention is that these strategies are generally going to help diversify a core bond allocation, but many investors are rear-view oriented and we know that with retail investors the money isn’t quite as sticky as it could be,” he said.
The challenge for investors and financial advisers is doing enough research on the strategies being employed by the funds, and then stepping back and letting the portfolio manager use the flexibility of the mandate to navigate what has become an unprecedented bond market environment.
“If you look under the hood of these funds, you’ll find that some are going to be short United Kingdom duration and some are short Japan duration, so in some ways you are trusting the manager’s skill,” Mr. DePalma said. “Understanding the strategies and what environments make them work is important, but some people spend more time shopping for a car than they do looking at what their portfolio managers are doing.”
David Harris, senior investment director for fixed income at Schroder Investment Management North America, said the best thing that could happen to the nontraditional bond fund category would be some market volatility and rising interest rates.
“Not until you get some sustained negative performance in traditional bond portfolios will you see what these [nontraditional funds] can do,” he said.
Schroder launched the $125 million Schroder Global Strategic Bond Fund (SGBNX) a year ago, modeling it after a $2.5 billion portfolio it manages out of Luxemburg, Germany.
“We have high expectations for the asset class,” Mr. Harris said. “We think it can act both as a diversifier in fixed income and as a potential replacement for traditional fixed income.”