What are 46% of Investors Afraid of?
Can this New Kind of Fund Protect You from Higher Interest Rates?
What Kind of Investor are You?
What are 46% of Investors Afraid of?
We often write here about how fear and greed are the two emotions driving investors.
When investors in aggregate are feeling greedy, the market can race ahead for months or years, even as more “level headed” commentators warn that equities are overvalued and enthusiasm is frothy. But the more money that’s made, the more greedy investors get-both those making the money and those still on the sidelines, wishing they were the ones making the money.
Eventually (usually shortly after the bystanders’ greed has gotten them off the sidelines) fear resurges and everything comes crashing down, causing a lot of people to lose a lot of money. Losing money can trigger an even more emotional response than making money, and the fear caused by a crash can linger long after the pain is over.
Today, for example, Gallup says only 54% of Americans have any money invested in the stock market, up only slightly from multi-year lows hit last year.
Participation in the stock market has actually been falling since 2008, even as the market has advanced over 100% (from 2009’s lows, the S&P is up 123%, the Dow 107% and the Nasdaq 150%). The fear hangover persists, years after investors “should” have started getting greedy again. That persistent fear can lead investors to make some odd choices in an attempt to find perceived safety.
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Can this New Kind of Fund Protect You from Higher Interest Rates?
One side effect of the last few years’ high and persistent levels of fear has been the development of a new type of bond fund that claims to mitigate, and even benefit from, coming interest rate increases.
Investors have always been taught that bond funds are very safe, but today they’re also being told to worry about the effect of interest rate increases on these funds. So a fund that is safe like a bond fund but not affected by rising interest rates sounds very appealing.
These funds go by the name “unconstrained bond funds” and they’re getting popular.
From the end of 2012 to the end of the last quarter, $67.6 billion flowed into unconstrained bond funds, nearly doubling the amount invested in the sector, to a total of $135.8 billion.
Unlike traditional bond funds that are tied to a benchmark and have to invest in essentially the same securities as the benchmark, unconstrained bond funds can invest in a broad range of securities at the discretion of the fund’s manager. That usually includes all types of fixed income securities-from short-term treasury bonds to high-yield corporate bonds to emerging markets debt to mortgage- and asset-backed securities-and can also include derivatives and even equities.
The managers of these funds claim that this freedom allows them to boost yield in today’s low yield environment, and will let them benefit from rising interest rates. But it also makes it hard to know what you’re buying: a fund that holds primarily investment-grade securities today could start stocking up on junk bonds and high yield mortgage backed securities tomorrow, leaving you exposed to a lot more credit risk than you thought you agreed to.
Their yield-boosting claim also falls rather flat, since many of these funds currently yield less than 1%. The PIMCO Unconstrained Bond Fund (PFIUX), one of the largest, currently yields only 0.95%, while charging annual fees of 0.90%. (Funds in the unconstrained category charge a 1.18% fee on average.)
Their performance has also been lackluster: the category has underperformed the Barclays U.S. Aggregate Bond Total Return Index over the past five years and year-to-date, although they did outperform in 2009, 2012 and 2013.
And the category’s history is simply not long enough to support the claim of being able to manage interest rates. As Morningstar analyst Eric Jacobson wrote in an article on the funds earlier this month, the idea of giving fixed income managers freedom to manage interest rate exposure isn’t new, in fact, it has been tried and abandoned:
“A number [of investors] got a rude awakening when interest rates spiked in 1994, though, and some managers were caught badly off-guard. Why? Macroeconomic calls are really hard to make consistently. Some of the worst damage occurred among funds that had gorged themselves on very long-duration mortgage derivatives (does anyone remember the names Piper Jaffray Institutional Government Income and Worth Bruntjen?), but legions of investors who owned funds with smaller losses were still shocked. Huge numbers of them had been talked into fleeing the painfully low rates on their CDs by brokers breezily pitching the virtues of government-backed mortgages. And it didn’t help that some popular balanced funds had aggressively trafficked in emerging-markets debt that swooned in 1994, as well.
“Within a few years’ time, just about every bond-fund manager had adopted what had previously been considered institutional management best practices and in particular began benchmarking their portfolio durations in a modest range around an index. Even more telling, however, is that, until the rise of the unconstrained funds that dominate the non-traditional-bond category, almost every single manager’s marketing pitch involved claims that nobody could consistently and successfully manage interest-rate bets of any size and that it was obviously folly to take bets big enough that they could threaten to dominate a portfolio’s returns.
“There are a lot of fund marketers out there today who either weren’t in the business just a few short years ago or who have evidently suffered a miraculously collective touch of amnesia.”
Jacobson goes on to point out that few of the unconstrained funds were around during the 2008 crisis, and only half were even around for the 2011 European debt panic and the following U.S. Treasury bond flight to quality. “Without a more serious credit-market stress test,” he concludes, “it’s extremely difficult to know how vulnerable most of these funds might be in the event of a nasty downturn.”
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What Kind of Investor are You?
In short, investors turning to unconstrained bond funds out of fear may actually be setting themselves up for a lot more pain than they’d find in supposedly “riskier” assets, like equities.
And even if these funds can do what they claim, they’re awfully expensive and not very rewarding in the meantime.
That’s the conclusion one of my subscribers came to recently after emailing me with a question about Scout Unconstrained Bond Fund (SUBFX or SUBYX), which his money manager had bought for his portfolio. After I explained the premise of unconstrained funds, he wrote back:
“Thanks for the explanation, that helps a lot. This issue was bought as part of an effort to make sure I was ‘protected’ against the inevitable ‘recession.’ However, it certainly seemed to me the fees weren’t worth holding a 1% yielding fund which didn’t pay its own way while I waited for financial Armageddon.”
I couldn’t agree more, and I’m glad the subscriber has decided to “reclaim” his investments from that Chicken Little money manager, who, he said, “bought gobs of bond-ish issues.”
It doesn’t pay to be among the 46% of people too afraid of “financial Armageddon” to actually get in the market while it’s going up. If you’re also interested in reclaiming the reins to your investments, we’re here to help. An easy way to start is to click here to take our simple quiz and find out what type of investor you are.
Sincerely,
Chloe Lutts Jensen
Chief Analyst, Cabot Dividend Investor
