Investing in what is called an unconstrained annuity fund is like a team building exercise where you fall backwards into someone’s arms: it can work, but it takes a lot of trust.
These funds have a far greater outlook on their holdings than a typical core bond offering that a portfolio could anchor. You can usually buy bonds regardless of their credit rating or the country of issue. Often times, they can also include currencies, derivative and convertible securities, and even stocks.
Because of their flexibility, they have the potential to generate higher returns than funds that only own US Treasuries and investment grade corporate bonds. However, the complexity of casual funds can make it difficult for less discerning investors to unravel their risks.
And that can lead to unwanted surprises, especially in times of market turbulence. In the first quarter of 2020, as the stock market plummeted in the wake of the pandemic, casual annuity funds tracked by Morningstar, the investment analyst, lost an average of 7.6 percent. The funds achieved an average return of 3.54 percent in the fourth quarter. In contrast, consider the iShares Core US Aggregate Bond Exchange-Traded Fund, which invests in US Treasuries and investment grade bonds and tracks the benchmark Bloomberg Barclays US Aggregate Bond Index. The fund achieved a return of 3.06 percent for the first quarter and a return of 0.73 percent for the fourth quarter.
Longer-term, the average fund has outperformed with no restrictions, producing an average total annual return of 2.86 percent over the past decade, compared to 3.76 percent for the iShares fund.
Recently, the lure of unlimited funds has been their return: in a world of meager interest rates, they can offer more returns than traditional pension funds.
As of December 31, the average 12-month trailing return of unrestricted funds was 3.19 percent, while the iShares fund was paying 2.17 percent.
However, a higher yield can lead to confusion.
“When you buy a fund with no restrictions, you really don’t know what you’re getting unless you look carefully at the portfolio and read the analyst reports,” said Steve Kane, co-manager of the TCW Metropolitan West Unconstrained Bond Fund. “You could buy a global macro fund that is invested in currencies or a disguised high-yield bond fund.”
This kind of vanity even characterizes Mr. Kane’s fund. “There is very little we cannot do,” he said. Still, he said he and his co-managers avoid betting on currencies, stocks or convertibles because they believe they are better at choosing bonds.
Her portfolio consists mainly of corporate and mortgage bonds and asset-backed securities. Asset-backed securities are pools of assets such as credit card receivables or car loans that are securitized as bonds.
The fund’s retail units have had an average annualized return of 5.2 percent since 2011, the year the fund was launched.
Given the current low interest rates – the 10-year Treasury Department pays about 1 percent – Annie McCauley, senior vice president of Sequoia Financial Group in Akron, Ohio, described casual funds as “a solid maybe” for retail investors.
A juicier return on its own shouldn’t encourage people to invest in something they don’t understand, she said.
“You can’t have a higher income or compromise to get that,” she said. “You have to recognize that the downside of an unconstrained fund might be more like an equity fund than a bond fund,” she said.
One way to get an idea of the typical zigzag lines in fund returns is to check the monthly numbers, she said. Investors sometimes focus on longer-term measures like three and five year returns, but these can make up for monthly jumps and dives.
Managers of unrestricted funds recognize that the higher income from their offerings may come in part from purchasing riskier tariffs such as high yield and emerging market bonds. But they also say their wide betting baskets can help reduce risk.
“People see ‘casual’ as what we can hang on the chandeliers,” said Rick Rieder, senior manager of the BlackRock Strategic Income Opportunities Fund. “What it really means is that we can use a number of tools to reduce the risk. We try to make some money all the time and not put all of our eggs in one basket. “
Most recently, Mr. Rieder’s fund included investments in high yield and emerging market bonds, residential and commercial mortgages, government bonds, derivatives and secured loan obligations. (CLOs are groups of loans, often corporate loans or loans to finance buyouts, that are pooled and securitized.)
At least one measure resulted in this eclectic mix producing a fund that was less nervous than its peers: the standard deviation of its returns was 5.15 percent, compared to 6.47 percent for the average unconstrained fund tracked by Morningstar. A lower number indicates lower volatility.
Mr. Rieder’s fund achieved an average annual return of 3.52 percent over the past decade.
The diverse holdings of an unrestricted fund can also help reduce the overall risk of an individual’s portfolio and add to the core holdings of bonds, said Marc P. Seidner, lead manager of the PIMCO Dynamic Bond Fund.
This is because the fund’s investments don’t necessarily correlate with the level and direction of US interest rates, which determine the return of typical pension funds, he said.
An unlimited fund could help protect against rising interest rates, he said. (Bond prices fall when interest rates rise.)
Higher rates currently seem unlikely as the coronavirus weighs on the economy. But once people are vaccinated, they will travel, eat out and shop in brick and mortar stores again.
“If you look at our portfolio, there is an element that has Covid Recovery built into it, like convertibles issued by cruise lines and airlines, hotels and some retailers,” Seidner said. The fund’s recent investments have included convertible bonds from Royal Caribbean Cruises and Southwest Airlines, as well as bonds from Carnival Corporation, a cruise line, and Delta Air Lines.
The PIMCO fund has achieved an annual average of 3.76 percent since it was launched in 2008.
When choosing a non-restricted fund, determining the risks it is taking is crucial, said Karin Anderson, research director for fixed income managers at Morningstar. This can be a big challenge too.
“It can be difficult for an individual investor to analyze what is going on,” she said. “Half of the holdings could be derivatives and you wouldn’t know what was hedging what or what they were exposing you to.”
Unrestricted funds are often not compared to known broad market bond indices. sometimes they are not rated at all. Instead of just judging how a fund fared against a common benchmark like the Bloomberg Barclays US Aggregate Bond Index, you may also want to compare it to peers or borrow a benchmark from another asset class.
“When a fund is high-yielding, it’s fair to see if it outperforms a traditional high-yield index,” said Ms. Anderson.
Valuation of fees is also essential as unrestricted funds can be expensive, she said. High fees weaken the return; Morningstar has found that they are predicting poor fund performance.
The average unlimited fund has a net expense ratio of 1.2 percent, while the average Intermediate Core Core Bond Fund – one that invests in investment grade government and corporate bonds – has an average expense ratio of 0.79 percent, according to Morningstar having.
Ultimately, you need to make sure that a fund manager’s goals align with yours and understand the tradeoffs you will accept with that person’s strategy, said Arif Husain, manager of the T. Rowe Price Dynamic Global Bond Fund.
“If someone promises you a high income, there will be higher volatility and a higher correlation with the stock market. If someone promises you diversification, the tradeoff is lower income. In my experience, there is no such thing as a high-income diversification strategy. “