ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Unconstrained Bond Funds Fail to Deliver

June 18th, 2013

by Chris Maxey, Ryan Davis

of Fortigent

Stocks Grind Lower

Equity markets fought through a volatile week, but ultimately finished lower, as the Dow Jones Industrial Average lost 1.2% and the S&P 500 index fell 1.0%.

During a somewhat quiet economic week, releases were varied, but the focus remained on monetary policy and the possibility of a quicker than expected slowdown in asset purchases.

A bright spot last week was U.S. retail sales for May, which gained 0.6%, following an increase of 0.1% in April. Retail sales were surprisingly strong in the month, even when excluding the impact of autos and gasoline. Weakness in furniture and electronics was easily offset by strength in food and beverage, sporting goods and building materials. The rebound in retail sales is encouraging as it is likely to boost GDP growth this quarter.

Enthusiasm about the retail sales report was balanced by a mild decline in consumer sentiment. The mid-June University of Michigan Index of Consumer Sentiment fell to 82.7 from 84.5 at the end of May. Readings on the current state of economic affairs was the primary culprit behind the decline as consumers were largely neutral on the economic outlook.

Inflationary pressure appeared robust in May. The Producer Price Index increased 0.5% for the month. Much of that change occurred from higher food and energy costs. Excluding the impact of those two segments, PPI was up a modest 0.1%. In the past year, headline PPI is up 1.8% and ex food and energy-PPI is higher by 1.6%.

The final piece of important economic data in the U.S. was industrial production. In May, industrial production showed a slight uptick, improving upon a 0.4% decrease in April. Manufacturing was a tailwind for economic growth in recent years, but that trend has been slowing in the last few months. Manufacturing output was up 0.1%, but declined in March and April. Auto production was a lone bright spot.

Although it was a quiet week in the U.S., officials in Japan remained on investors’ minds. On Tuesday, the Bank of Japan (BoJ) concluded its two-day monetary policy meeting and, despite traders’ expectations of further stimulus measures, the Bank held steady on its current plans. The BoJ concluded that economic activity “has been picking up” on account of improving export growth.

Unconstrained Bond Funds Fail to Deliver

There have been an incessant number of articles in the past year addressing a “Great Rotation” by investors – the seismic shift in asset allocation predicted to result from a transition to a rising rate environment. Individual investors “spoiled” by a 30-year secular decline in interest rates, it is thought, will run to new alternatives in the face of this structural headwind for a significant chunk of their portfolios.

While the timing and possibility of such an event is subject to intense debate, there is no denying the fact that investor flows into bond funds have slowed markedly, according to data from the Investment Company Institute (ICI). This phenomenon is partly driven by performance: following a 13-year run of positive returns, the Barclays Aggregate Bond index is languishing in negative territory this year amid higher interest rates.

Poor performance this year in bonds has helped crystallize many investors’ fears that the inflection point for rates is near. The Fed’s posturing on quantitative easing – despite the fact that the FOMC remains ardent in its support of low interest rates – only serves to inflame those concerns. Investors are looking beyond their traditional plain vanilla offerings for their fixed income portfolios, and this has coincided with a spate of new mutual fund offerings in the unconstrained or non-traditional space.

Since 2009, the number of funds in the Morningstar Nontraditional Bond category has grown sharply. From 20 funds four years ago, the universe now stands at 59 products. This number only stands to grow as more asset managers seek to tap into this source of investor demand.

Assets have increased more than tenfold in that time, growing from just $6.5 billion in the first quarter of 2009 to $90 billion in May 2013. A large portion of that growth has occurred in the past year, during which assets rose by nearly 60%.

This trend is likely to continue. Studies by consulting firms such as McKinsey & Co. and Casey Quirk predict rapid growth in alternative investment products over the next few years. McKinsey forecasts the market share of alternative investment mutual funds will double by 2015 to 13%, of which nontraditional bond funds will undoubtedly play a significant role. According to the Morningstar asset data, the nontraditional bond category has been the fastest growing alternative investment sector.

Unfortunately, the performance of nontraditional bonds funds in the past six weeks brings into question just how alternative they really are. These funds encountered their first major test in May, as Treasury yields backed up more than 50 bps on the heels of stronger economic data and rumblings that the Fed would pull back on its asset purchasing program.

Morningstar’s Nontraditional Bond category dropped 1.0% (median return) in that period, compared with a 1.9% fall in the BarCap Agg and a 1.8% drop in the BarCap High Yield index. While mitigating some of the damage in the long-only indices, 51 of the 59 Funds in this category lost money during this period. The breadth of negative performance in such products was staggering, given their more flexible and absolute return-oriented mandate.

It is clear from May-June performance that, while the majority of these funds have the ability to hedge rates, many were caught off guard by the sudden move. The top performing fund during the stretch was a fund that runs with a structural inverse duration to

intermediate-term Treasuries – hardly the profile of a nimble, all-weather manager that investors would hope for from this category. The fund’s own prospectus notes that the product is “not designed to be a stand-alone investment.”

On the bright side, there were a few funds that better fit the mold of a true, unconstrained manager who performed admirably during the past six weeks. At this juncture, however, such products are few and far between, and only one of those funds has a track record pre-dating 2010. Careful due diligence of this category will be paramount for investors in the months and years ahead, as they seek to distinguish the truly skilled managers who can deliver on the promise of unconstrained fixed income.

The Week Ahead

In contrast to last week, a number of key events will play a role in market direction this week. At the top of that list is the FOMC meeting on June 18 and 19. Recent economic data has been anything but hearty since the last meeting, so it is unlikely the Fed would reveal exit plans at this juncture. Traders will pay close attention, however, to any indication of a slowing in asset purchases.

In addition to the Fed, central bankers in India, Turkey, Switzerland, Norway and Egypt will meet this week.

This week will also bring several key data releases, such as Empire State manufacturing, housing starts, the consumer price index, existing home sales, and the Conference Board index of leading indicators.

For more information, please visit our website at http://www.Fortigent.com.

The information provided is general in nature and is not intended to be, and should not be construed as, investment, legal or tax advice. Fortigent makes no warranties with regard to the information or results obtained by its use and disclaims any liability arising out of your use of, or reliance on, the information. The information is subject to change and, although based upon information that Fortigent considers reliable, is not guaranteed as to accuracy or completeness.

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