Moderately Constrained

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The Barron’s cover story was an interview with Bill Gross from PIM….er I mean Janus that was titled Why Interest Rates Must Rise. The why they must rise part of the article focused on Gross’ perceptions of the many consequences of ZIRP and NIRP including the effect on retirees, pensions being able to match their portfolios with their liabilities, as well as how insurance companies oversee their pools of capital.

At Janus, Gross manages an unconstrained bond fund which is a fairly new category. Barron’s says this type of fund came about six or seven years ago, which has a very broad mandate to go find basis points anywhere it can (check the prospectus for any fund you’re interested it to see what it can actually do).

What was interesting to me in the article was the long list of strategies Gross is implementing in his fund to try to deliver some yield while trying to avoid taking interest rate risk. He talks about using merger arbitrage, closed end funds which of course use leverage, other forms of leverage, a core of shorted dated corporates as well as selling options on US treasury product in various combos that annualize out to many more basis points than just buying treasuries directly.

The point of this post is not to try to assess whether the conclusions Gross draws are correct or to agree/disagree with what he is doing in the portfolio. That he is doing these types of strategies, right or wrong in this environment, ties into what we have been writing about here for years in terms of needing to be innovative in order to construct a portfolio that delivers yield while hopefully minimizing exposure to the obvious risk out there which is interest rate risk.

In terms of trying to find bond proxies, many have suggested more exposure to dividend paying equities which I have maintained is a terrible idea. Equities that have high dividends or growing dividends or any other kind of dividend are not bond market proxies, they are equities and should be expected to trade like equities not bonds. There is nothing wrong with dividend oriented equities (although I would not suggest owning them exclusively in an equity portfolio); I am simply saying they are not substitutes for bonds.

In the above paragraph, the word equities could be replaced with the words REITs or MLPs and read the same. During the Great Recession ETFs tracking REITs went down much more than the broad equity market. Over the last year and half one of the larger MLP funds is down over 40%. Both niches are valid exposures but those are not bond like returns.

If you look, you will find plenty of articles on Seeking Alpha recommending equities as bond market substitutes and other articles suggesting 15, 20, even 25% to things like REITs and MLPs and this is terrible advice.

I agree with Gross that merger arbitrage can be an effective bond substitute in terms of total return. The space struggled during the financial crisis during the time when capital markets stopped functioning. This is something that has an extremely low probability of ever happening again but that risk is mitigated when you allocate 5% to some sort of alternative strategy as opposed to 20%.

The starting point for understanding is that a simple mix of equities and bonds can still get the job done. Where that is the case then the goal with unconstrained-like strategies is simply to tweak the portfolio’s behavior or replace a trouble spot in a normal allocation, like long term treasuries, with something that might offer a similar return but do avoid whatever risk you’re trying to avoid. With respect to equities, small exposures to alternatives might be best thought of as hopefully reducing volatility a little, or maybe reducing correlation a little.

The next time some alternative segment becomes popular, probably because it was a top performer, people will come out of the woodwork to recommend a 20% allocation and that will be terrible advice. Small exposures to three or four alternatives can go a long way to altering the volatility profile of a portfolio as well as sidestepping some segment with heightened risk factors.

I’ve been writing about small exposures to what I called diversifiers since long before unconstrained became a term (if Barron’s timeline is correct), so I still think of it in those terms but it seems like it is consistent with the unconstrained concept so I guess I am on board with it…but in moderation.

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