When Investors Call the Shots for Portfolio Managers

UNCONSTRAINED BOND FUND, n. A mutual fund, specializing in bonds, that places no limits on the number of ways in which it can provide disappointing results to its investors. – Jason Zweig, The Devil’s Financial Dictionary

Investors often get exactly what they’re asking for, even if what they’re asking for will damage their performance.

One of the reasons there are so many closet index funds is because investors don’t like tracking error. Being different than the market can be uncomfortable.

One of the reasons hedge funds have performed so poorly in the past decade is because investors have been so risk averse following the financial crisis. They wanted lower volatility and downside protection and that generally comes with lower returns.

One of the reasons unconstrained bond funds have performed so poorly is because investors are so nervous about rising interest rates. Positioning for rising rates doesn’t work out so great when rates keep falling.

The new bond king, DoubleLine’s Jeffrey Gundlach, discussed the problems with unconstrained bond funds in a recent interview with Investment News. Some highlights that stood out to me:

On why the category is misleading:

“Unconstrained bond funds are actually constrained in terms of the purpose investors are using them, because if you’re running an unconstrained fund you probably know investors are looking to avoid rate risk.”

“It’s strange, because you’re allowed to be unconstrained, yet nobody does it because they know investors are not looking to market-time interest rates, they’re looking to sidestep interest-rate risk.”

On why the fact that Morningstar’s nontraditional bond fund category averaged a gain of 29 basis points in 2013 while the Barclays US Aggregate Bond Index lost 2.02% says more about credit exposure than interest-rate hedging:

“Some of those funds really shined in 2013 because they are generally avoiding rate risk, and because credit did really well that year. And since it worked that one time, there was enthusiasm for the strategy of being credit-heavy.”

“Rising interest rates lead to losses across the bond category. It’s not like these funds are going to have some super-secret bond allocation in credit that goes up when everything else is falling.”

“Nothing works all the time, but unconstrained funds give this kind of false promise that they might work all the time. It’s not like it’s risk-free. It has to be managed almost perfectly.”

This critique is perfect. While positioning their funds as being unconstrained, they have actually become very constrained in what they can do. Obviously, you can’t place all the blame on investors as the PMs are still the ones calling the shots, but they’re just doing what the investors want them to do. If you’re an unconstrained bond fund manager you absolutely cannot get caught on the wrong side of rising interest rates.

Bond investors have been fearful of rising rates for a number of years now. If those investors hedged their interest rate exposure that entire time and then saw losses when rates finally do rise they would be furious. So unconstrained bond funds have no choice but to either sit in cash or take their duration down in anticipation of higher rates.

I watched a panel of unconstrained bond fund managers a couple of years ago at a conference. All three worked for very large bond shops. Each had an interesting sounding narrative for their strategy. And all three had the majority of their fund allocated to cash (anywhere from 60-95%). All basically said the same thing when asked about their current positioning — we’re waiting for better opportunities to put deploy capital at higher rates. Translation: Interest rates have fallen and we absolutely cannot invest until they rise from here (of course they have continued to fall ever since).

Looking for better entry points to put capital to work sounds like a really intelligent in theory. And it can be with the right process and manager. But very few can successfully pull off going from risk assets to cash back to risk assets multiple times, especially in the fixed income space.

As Gundlach notes, investors are constantly searching for that super-secret investing strategy that works in all environments. What they get are unintended consequences and risk because the PMs of these funds have to worry about fund outflows if they’re wrong or don’t do what the investors expect them to do.

Expecting a bond fund manager to traverse the interest and inflation rate environment perfectly is a ridiculous goal. Some unconstrained bond funds may end of performing well if and when we do see a sustained rise in rates. Investors have to ask themselves if it’s worth the risk of missing out on bond coupon payments in the meantime and whether or not these PMs will be able to deploy capital at the right point in the rate cycle to take advantage on the other side.

Color me skeptical of the majority of go-anywhere funds.

DoubleLine’s Gundlach calls unconstrained bond funds a ‘gimmick’ and constrained (IN)

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  1. Luke commented on Jan 07

    Very good write-up. I hope this gets read widely.

    Interesting seeming contradiction: Gundlach says, “It’s strange, because you’re allowed to be unconstrained, yet nobody does it because they know investors are not looking to market-time interest rates, they’re looking to sidestep interest-rate risk.” Yet fund managers looking for better entry points sounds exactly like market-timing.

    • Ben commented on Jan 08


  2. Keith G commented on Jan 08

    Often times, I look at things like this and wonder why.

    I invest in bonds (primarily treasuries) because they, generally, provide a negative correlation to stocks while providing some investment return.

    With a unconstrained bond fund, I lose that insight into what the correlation is to stocks, and I get to pay a higher expense ratio.

    Worst yet the performance of these investments are tied to the ability of the manager to predict future interest rates, which really goes against my fundamental view that the markets are best understood as a stochastic process and while we have some insight to possible outcomes, no one has a crystal ball of perfect predictions.

    For me I’m going to stick to the KISS (Keep It Simple, Stupid) principle.


    • Ben commented on Jan 08

      Good point about these funds being more unpredictable. Losing that huge benefit that bonds give you is a large risk most don’t think about.

  3. Ryan commented on Jan 08

    >Expecting a bond fund manager to traverse the interest and inflation rate environment perfectly is a ridiculous goal.

    Ridiculous to us, maybe

    According to the clients, portfolio manager, and marketing team that is exactly what we should expect. How else are investors going to match the index after paying 2%/yr in fees?

  4. Grant commented on Jan 08

    Excellent post, Ben. My simplistic take on this: The best predictor of future interest rates is the current yield curve, so that if you are going to do better by shortening duration as interest rates go up, rates have to go up more than the yield curve predicts. Buying the total bond market index fund, which is cheaper and more likely to be right than these other options seems a good deal.

    • Ben commented on Jan 08

      Yup it’s funny how few investors get how important the starting yield is for their long-term returns. Much easier to predict bond returns than stock returns.

  5. John Richards commented on Jan 08

    Great post. It seems to me that Globalization, and the process of learning how to apply technology effectively, are both still in full swing and have years to run, in one form or another. I suspect there is potential for inflation and interest rates to remain historically low for a long time, as the latest employment and wage data might suggest (at least, that’s how I interpret it).

    I don’t fear bonds nor REITs, but complexity seems undesirable. Life is much easier when I can place at least a little faith in historical correlation coefficients. After years of all sorts of different portfolios, here I am after 20 yrs of investing, using a boring 60/40 mix with the 40% all in US treasuries, mostly intermediates. (I guess the equity portion is kind-of smart-beta-ish, so it’s not entirely boring!)

    • Ben commented on Jan 08

      Many investors have (smartly) taken this route of taking risk where it makes sense (stocks) and avoiding risk as much as they can in bonds. Something of a barbell approach.