Over the past several years, so-called unconstrained funds have fallen in and out of favor with investors; arguably for good reasons. Despite their classification as unconstrained, most such funds actually do operate within self-imposed constraints. Therein lays the challenge for investors. Industry defined parameters around unconstrained funds don’t exist. Each manager can design his or her strategy however they choose. The result has been significant dispersion of returns across managers and, in some years (2014 and 2015, in particular), average performance that lagged traditional fixed income as represented by the Bloomberg/Barclays US Aggregate Index (“Aggregate”). It was not uncommon for a top performing manager in one year to become a bottom performer in the next. See the below chart for the range of returns in the Morningstar category for non-traditional fixed income funds.
Investors buy fixed income as a lower volatility component in their overall portfolio that, by design, should lower rather than increase the dispersion of overall returns. The fallout from unexpected volatility in the performance of unconstrained funds has resulted in a steady outflow of money from them.
Now that the Federal Reserve has begun raising overnight rates in the US, it may be an excellent time to revisit these unconstrained strategies. Traditional fixed income strategies such as those managed relative to the Aggregate index, for example, generally do not perform well as rates rise. With roughly five years of duration and 2.65% yield, a 50 basis point increase in rates would offset a year’s worth of yield. Could this happen? 10-year Treasury yields rose by 56 basis points in the month of November 2016 alone. In the five periods of rising rates since December 2010, four have exceeded 50 basis points. See below chart. With the Fed poised to raise rates three more times in 2017, the probability of a similar rise along the yield curve is increasing.
When rates rise, bond prices fall. However, that does not mean that all fixed income investments will lose money. We believe that well diversified strategies with the flexibility to invest in all of the sectors available in the global fixed income market and that actively manage duration can provide attractive returns regardless of the interest rate environment.
Conclusion: Choose Wisely
The impetus to invest in unconstrained strategies post crisis was clear. Rates could only move higher following years of unprecedented accommodative policy; a fixed income flexible approach with less rate sensitivity seemed a failsafe solution. The case for these strategies has certainly been muddied by inconsistent performance across some of the largest funds in the universe, in addition to resilient performance from traditional bond investments as global growth has remained sluggish and duration has outperformed. The general flexible approach however, should not be cast aside. Unconstrained managers can be effective complements to traditional fixed income allocations, improving risk-adjusted returns over time, as our analysis shows.
Return dispersion in the universe, however, offers clear evidence of heterogeneity across the very broadly defined unconstrained category. While flexible managers certainly should not be dismissed, their individual approaches should be carefully scrutinized and understood in the context of the investor’s broader fixed income allocation and risk tolerance. In short, with an unconstrained allocation, one is substituting traditional benchmark risk for manager risk. We still advocate strongly for the benefits of an unconstrained strategy and believe analyzing a few key factors, highlighted below, can help investors better evaluate these managers.
 Yield and duration estimates as of January 31, 2017.