Despite a stock market that has roared above its March 2009 lows, here is how worried investors are: The traditional “safe-haven” investments of U.S. dollars and Treasuries are viewed with skepticism. Where to hide?
Kevin Kearns, the manager of Loomis Sayles' Absolute Strategies fund, lays out the issues. “QE2 [quantitative easing, round two, in which the government buys its own debt, in effect printing money] puts pressure on the dollar to go down and forces up commodities. Currencies are relevant to U.S. consumers; for proof you have to go no further than the gas pump. Investors should consider not only the nominal return of their investments but the purchasing power of these instruments after adjusting for currency fluctuations,” Kearns told us recently.
JP Morgan Asset Management says, “Imports represent a much larger share of the economy (as measured by GDP) than exports, and will feel the effects of currency fluctuations more. Imports as a percent of GDP have grown from 10 percent of the U.S. economy to 16 percent in the last 30 years.”
What to Do?
So what should advisors do about it? U.S. Treasuries have been the default “risk-free” choice for decades, and it remains true there is little likelihood of actual default. But advisors should broaden their definition of risk-free, and also consider long-term interest rate trends and purchasing power, as well as the volatility of annual returns.
Consider the prestige of Treasury bears. “I think Treasuries will be a poor choice for most of the next 20 years,” none other than Dan Fuss of Loomis Sayles told us. Advisors should deemphasize Treasuries, and add greater amounts of corporates and sovereigns, both domestically and abroad. Consider using the JP Morgan imports as a percent of GDP data as a proxy for a recommended weighting in foreign fixed income investments.
Mutual fund families are offering new choices to fit these needs via a host of new “unconstrained” bond funds. Unconstrained funds pursue absolute returns and often use low duration strategies. Some can also pursue a long/short strategy, betting against certain fixed income instruments as well as going long other fixed income.
These types of funds are not new. In fact, in some ways, unconstrained funds represent a return to the old-school style of bond fund management. “It was common in the 1980s and much of the 1990s for bond-fund managers to make big bets on the direction of interest rates. Some employed considerable flexibility to invest across sectors as well,” Eric Jacobson of Morningstar wrote in a piece analyzing the new offerings.
Of course, the go-anywhere funds are not without risk; managers have the freedom to bet on yield curves, asset classes, and currencies. To generate returns, their bets have to pay off. This is an obvious point, but some advisors find the notion of such broad mandates to be inherently risky, pointing to higher levels of “tracking error,” the statistical term for deviation from expected relative returns. On the other hand, in the right manager's hands, the freedom to go anywhere provides additional forms of diversification, and potentially stable absolute returns. These funds should not be considered truly “risk-free,” but can be used to diversify fixed-income portfolios and reduce exposure to Treasuries. (And besides tracking error became religion during the 1990s buying panic; in short, when the market is going up, be the market!)
Some Choices
So which unconstrained funds are worthy of consideration? PIMCO Total Return and Loomis Sayles Bond Fund are the most well known, and with the help of Morningstar, we compiled a list of unconstrained funds to watch. We looked for funds with extensive research capabilities, reasonable expense ratios, and established managers and analytic teams. The list includes established funds and newer entrants as well. “FPA New Income and Templeton Global Total Return have been run with an absolute return philosophy as well, and we are intrigued by Bill Eigen and think that he has a conservative approach,” says Miriam Sjoblom of Morningstar.
Bill Eigen, who manages the JPMOrgan Strategic Income Opportunities Fund, runs a thematic and idiosyncratic portfolio. The fund is long and short and invests globally. “The only benchmark we care about is T-bills,” says Eigen, who is bearish on a number of important bond sectors, including Treasuries, emerging market debt, and some corporates. “The fund is conservatively positioned, and every trade is modeled independently for fit, size and level. We spread the risk factors out,” says Eigen. He is short European sovereign debt as well as some Latin American credits, and trimming high-yield corporate exposure.
Kevin Kearns' absolute return fund is also worth considering. “We seek alpha in credit and strategic interest rate investments. From an overall risk perspective, we target 4 to 6 percent annual volatility. To mitigate risk, we spend a lot of time on scenario analysis and the best way to hedge tail risk,” says Kearns. He says he sees as many as six potential tail risks right now, including inflation in emerging markets, the negative impact of QE2 on the dollar, and European debt crisis contagion continuing to spread, reaching Spain and potentially impacting the entire EU.
Kearns' fund uses advanced hedging techniques to protect against these risks. “To hedge inflation risk in emerging markets, where we are long Asian currencies, we bought puts on the Australian dollar and the S&P 500, two instruments we believe to be at risk should our inflation tail risk scenario come to pass,” says Kearns. Like Eigen, he sees corporate high yield markets as fairly valued at best, leaving occasional opportunities. “Investment-grade bonds have good opportunities for corporate improvement, but we don't like the interest rate risks in this market since we think rates are headed higher,” says Kearns.
Kearns and Eigen are two worthy candidates from our list, but all these funds can be useful for both international diversification and low-to-medium duration bond exposure, allowing advisors to achieve multiple asset allocation goals with one fund. Using money markets for short-term needs, unconstrained funds for international diversification and medium duration exposure, and additional funds for long duration investments can help advisors simplify their fund choices while increasing diversification. That's a free lunch, if you will, of simpler fund portfolios and additional diversification factors.
