A Timely Look at Unconstrained Bond Funds

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Forgive us for quoting gobbledygook from a prospectus, but there’s a lesson here: Some bond funds can invest your money in virtually anything and describe this freedom in words fit only for a lawyer or a fund geek. For example, Legg Mason BW Alternative Credit (symbol LMAPX) strives for “positive returns independent of market cycles through a high level of income and capital appreciation.” Or you could say, the fund plans “to pay a high yield and always make money by investing in anything it chooses.”

To give the fund its due, so far it is a raging success. Since its creation as an institutional account four years ago, it has a spectacular annualized return of 20.6%, built by rotating in and out of concentrated positions in investments such as global high-yield bonds and U.S. mortgage-backed securities. Most recently, the fund scored big gains by investing nearly half of the shareholders’ money in Spanish mortgages. (The famous Pimco Total Return fund, from which Bill Gross just resigned, is also free to invest in nearly anything but returned just 3.6% a year over the same period.) Legg Mason offered shares to the public starting in December, and through September 25 its year-to-date total return is 12.4%, with a current yield of 2.2%.

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LMAPX is and always will be unpredictable. Gary Herbert, one of the managers, says the team constantly debates what is cheap and capable of gaining the most value over the next year. Then the fund loads up on this stuff. Herbert says these selections are not cavalier and that the staff conducts stress tests on all of its holdings. Nevertheless, the fund is much too flamboyant to trust for essential income or principal protection. The same is true of its dozens of cousins.

Be warned that the fund-marketing machine is working overtime to hype such tactics as an appealing replacement for simpler income funds that look vulnerable if the bull market in bonds finally ends. The labels may be “alternative,” “nontraditional” or, most daringly, “unconstrained.” Gross and his new employer, Janus Funds, are using that last word on the fund he’ll run. Many of these funds are managed on the premise that interest rates are insanely low and only an unorthodox set of hedging strategies and big bets can produce a gain. That describes Scout Unconstrained Bond Fund (SUBYX), launched in 2011 to craft a portfolio that is “less vulnerable to higher interest rates and enduring economic uncertainty.” Neuberger & Berman Unconstrained Bond (NUBAX) appeared in January and is chock full of short positions in Treasuries, so far a wrong-headed gamble. Both it and Scout are losing money this year. Three-year-old Federated Unconstrained (FUNAX) has a puny annualized return of 0.75% since 2011.

The Legg Mason entry isn’t the only winner. (Kiplinger’s likes Metropolitan West Unconstrained Bond (MWCRX), a member of the Kiplinger 25, a list of our favorite no-load mutual funds. Since its inception in 2011, MetWest has produced a 10.1% annualized return. It differs from many of the other funds mentioned here because it is required to keep the duration shorter than eight years and emphasizes capital preservation rather than taking big swings.)

High marks also go to Cedar Ridge Unconstrained Credit (CRUPX), born in December 2013 as the first public fund offered by a hedge-fund partnership from the hedgers’ mecca of Greenwich, Conn. Cedar Ridge also promises capital gains and income—don’t they all?—by trading without boundaries. It has a return of 11.4% this year from an odd marriage of junk municipal bonds and profitable short positions along the only part of the Treasury bond yield curve (about five years) where interest rates are up and T-note prices down. You could say Cedar Ridge is two for two while most other unconstrained funds keep striking out.

But is it possible to foretell which alternative fund, if any, can regularly make money? Jeff Hudson, a Cedar Ridge partner, doubts that more than a handful will work this magic. He says short selling, one of the funds’ primary strategies, is an art that backfires on the majority of managers. One-time jackpots, such as gains won by scarfing up unwanted Spanish mortgages, are not sustainable even if a few Legg Mason managers have gotten nearly everything right consistently since 2010.

Hudson dislikes the word unconstrained, though his fund uses it. He thinks it will become a synonym for a sure-thing, bear-market-beating bond fund, although there is no such species. “It is too cute and easy to say that this fund or that one will perform well in a rising-rate environment,” Hudson says. “There is a natural tendency for marketing people to develop products to appeal to people’s paranoia about a rate move, when we know it is impossible to forecast rates.” Hudson bought risky junk munis last winter not only because he sensed the bonds were underpriced but also because there were so few other buyers that he could get them for peanuts. The fund’s present 2.2% yield is mostly tax-free. But that’s incidental because Cedar Ridge Unconstrained may flip 100% of its holdings at any time. It’s just another black box despite the innocent-sounding objective. And when you open a black box, you don’t know what you will find.