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Recently, Mohamed El-Erian, CEO and co-CIO of PIMCO -- one of the largest, if not the largest, fixed-income management organizations -- penned an insightful article about what's happening to bonds titled "What's Happening To Bonds And Why?" Unless you've been in the dark (which would not describe a typical reader of Seeking Alpha), the turmoil in global bond markets due to anticipation of the Federal Reserve's reduction in bond purchases has created historic velocity in the move of the intermediate and long end of the yield curve, and technical dislocations in emerging markets bond investments. Throw in the turmoil in Detroit and municipal investments across the yield curve have experienced pain, too.

It's a challenging time to position fixed-income dollars within an asset allocation program. Even in 1994, which was tough, I did not face such a frustrating situation since there was no grand Fed bond buying program at the time. The chatter in the adviser community in the face of unprecedented central bank action and little, if any, historical context is to depend on active managers to figure it out, which in some way appears plausible.

However, we've seen the PIMCO Total Return Fund (NYSEARCA:BOND) suffer heavy redemptions -- roughly 14% of its assets over the past four months. If Bill Gross with 30 years of experience can't figure it out, how can the adviser community? Even bond manager wunderkind Jeffrey Gundlach has vacillated when it comes to his opinion on where the 10-year Treasury yield is going to be at year-end.

In the face of this challenging environment, the advisers I come across feel comfortable placing greater portions of their fixed-income allocations into "unconstrained bond funds." Unconstrained meaning absolute return strategy; a rebel against a bond market benchmark; a focus on downside risk management; the primary reliance on the skill of management to drive performance; a broad interest-rate mandate that allows management to be negative duration. It sounds plausible how, in the face of bond market turmoil, investors and professionals would desire a pure active management solution and augmented interest-rate mandates to tackle fixed income. I decided to look closer before committing dollars.

Observations

First, I require a benchmark for, well, benchmarking. How am I supposed to determine whether these managers are doing what they say they are doing? So, even though I like the idea they're not handcuffed to the benchmark -- which allows management to be "unconstrained" -- as a money manager I require a method of comparison. Morningstar utilizes a category of "NT," or non-traditional. I can also rationalize how unconstrained may compare to multisector since both are taking an opportunistic, active management approach to fixed-income management.

However, the unconstrained brethren truly begins from a "blank canvas" perspective to investing. Multisector funds will be required to follow the benchmark they track to some degree. I believed it best to determine how the unconstrained compares against the passive Barclay's U.S. Aggregate Bond Index. I also decided to examine several of the funds against a series of multisector bond offerings that are constrained to their respective benchmarks.

Second, it's not all about benchmarking. It's obvious from the literature provided by large, reputable firms like PIMCO and BlackRock that the managers of unconstrained funds plan to be dynamic and seek to aggressively manage interest rate risk, which is comforting to investors based on the volatility many bond funds have faced recently. Third, expenses matter. I was curious about how much "unconstrained" is going to affect my wallet. I'm fee-conscious but never let it get in the way of making a good long-term investment. However, it's important to understand how much this is going to cost me and my clients.

Results

When compared to the passive index, most of the funds have experienced respectable outperformance. Within the group, there exists wide disparities in the year-by-year total return numbers among the participants. For example, the PIMCO Unconstrained Bond Fund INST (MUTF:PFIUX) -- one of the largest in the group, with $29 billion in assets -- has returned 4.96%, 0.01%, 8.33%, and -2.54% from 2010 through YTD Aug. 31, 2013, respectively. The BlackRock Strategic Income Opportunity Fund (MUTF:BASIX) -- a popular choice among the adviser community -- has handily outperformed the passive benchmark through the same period with returns of 13.10%, -0.98%, 9.64%, and 0.26%, respectively.

Unconstrained bond funds claim to actively manage interest rate risk. Turnover tends to be high among the funds -- for example, 786% for PIMCO and 807% for the BlackRock offering. When I spoke to representatives, the high turnover in part is due to the management of this risk. Managers are cautious here with durations from short to ultra-short with BASIX at the shortest at 0.10 years. Not a big surprise since an objective of these funds is downside risk management. Expenses for the group do not invite sticker shock. They are about average for the non-traditional and multisector group, although much higher than (or almost double the) expenses of traditional actively managed fixed-income total return funds, which intuitively makes sense. Some, like the BlackRock offering, will carry additional load charges to compensate your broker.

Rules

  • It's best to focus your homework on management first. It's clear based on the wide range of performance within the segment that management matters. You are buying into the prowess and experience of a tenured group or person to time the bond market.
  • Do not purchase unconstrained funds for yield. If your broker or adviser is touting yields, which on the surface appear attractive, keep in mind you are most likely not going to earn them as capital appreciation and maximum long-term return are fund objectives. They are not appropriate choices for current income.
  • Prepare to be frustrated at times. Remember you're buying management, so if they underperform a few quarters, it's best to be patient as market timing is a lofty goal. How many investors are actually patient?
  • Some of the traditional rules don't apply. For example, I usually wait for new funds to generate a multi-year track record. With unconstrained bond funds I'm not certain I need to wait as I'm purchasing expertise first. If I'm confident with management's experience, it may be a good idea to own the fund. And with less asset bloat, managers may be more nimble to take advantage of opportunities or technical dislocations.
  • Monitor them frequently. I'm concerned these choices are purchased as a method to "set it and forget it." In other words, you or your adviser shouldn't let your guard down when it comes to monitoring at least quarterly. Be increasingly diligent to remain up to date with strategies management employs. Also be sensitive to dramatic under or over performance compared to peers. You may need to rebalance on a more frequent schedule than you prefer.
  • Tax drag may eventually become an issue. I would favor to own unconstrained funds in tax-sheltered accounts, especially if the high turnover I observe eventually results in significant short-term capital gain payouts (which are taxed as ordinary income).
  • This is not an entire portfolio solution or core holding. I would consider unconstrained bond funds as strictly opportunistic as they depend solely on active management. I'm open minded as more research is required to solidify my thinking. They will remain a "satellite" selection within my fixed-income allocations until additional empirical data is generated to prove me incorrect.
  • Consider other options. For example, if most of these funds are now short or ultra-short duration in approach, why not just lessen the duration of your fixed-income portfolio and do it at lower expense? The majority of ultra-short and short duration mutual funds are available at half the cost. Of course, this strategy will be more labor-intensive than just relying on the experience of an unconstrained bond fund manager who gets paid to make the moves. However, what do you pay your adviser for? In addition, multisector bond funds have performed in a similar fashion, and if I choose to go that route, at least I don't need to worry about benchmark risk.

It's an exciting time in the bond market as investors attempt to figure out how bonds and interest-rate-sensitive investments will continue to be impacted by the unwind from the Federal Reserve's grand bond purchase experiment. I'm not certain unconstrained bond funds are the answer; however, in the face of the end of the 31-year bond market bull run, they may turn out to be a smart addition to a fixed-income allocation. As of this writing, I don't perceive them as the panacea many professionals have already decided they are.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Unconstrained Bond Funds - Rules To Follow Before You Buy