It is easy to see why the unconstrained approach is so appealing to investors. By taking a ‘benchmark agnostic’ view, an unconstrained bond manager can actively position their portfolio based on their view of the future direction of yields or relative performance between sectors. This flexibility not only allows unconstrained managers to outperform the benchmark with the right strategy but can also provide additional diversification benefits due to low correlations with passive bond and equity funds.
With central banks locked in a tightening cycle, market volatility re-emerging after a period of relative calm, and geopolitical risks wreaking havoc in emerging markets, you might think unconstrained bond funds were made for these times. But assessing the effectiveness of unconstrained bonds means contending with the significant diversity within the sector, which combined with the relatively short track record of most unconstrained managers makes it difficult to assess performance through different market conditions. To understand how a particular fund might behave within a broader portfolio, investors need to get under the hood to see how the manager is generating returns and where they might be exposed to risk.
Lonsec’s peer group of unconstrained bond managers is indicative of both the growth within the sector as well as the diversity of strategies employed. Over the period from April 2017 to November 2018, most of these funds provided some level of diversification, with relatively low correlations against major equity and fixed income indices. However, Lonsec’s research shows that many unconstrained bond funds have to date been significantly correlated with high yield fixed income benchmarks, reflecting the additional credit risk inherent in many unconstrained strategies.
Unconstrained bond funds may have equity- or credit-like behaviour depending on their strategy
(correlation of returns with US equities and high yield indices)
This means that when high yield credit is underperforming, unconstrained funds may also underperform. The correlations are varied, which is largely due to the broad range of investment styles employed across the peer group.
The majority of funds in the peer group have exhibited a positive correlation to global equities (S&P 500 TR Index AUD) and emerging market equities (MSCI Emerging Markets TR Index AUD)—largely driven by their allocations to both investment grade and high yield credit—but have still provided some level of diversification away from these markets given less than perfect correlations. Ideally, unconstrained bond funds are expected to meet their return and risk targets while avoiding high correlations with high yield and equity. The purpose of unconstrained investing is not simply to provide a direct substitute for these higher risk alternatives—investors are looking for more flexibility, not necessarily more risk.
Investors should consider unconstrained bonds but should be confident that they understand what individual managers are trying to achieve. Is the fund using duration as a driver of alpha? Is it predominately defensive in its allocation? Does it employ leverage to amplify returns? Unconstrained bonds can help investors diversify their portfolio and provide additional alpha, but it is essential that investors have an idea of how the fund is likely to behave in different market conditions, especially when riskier sectors start heading south.
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