Why Fear Doesn’t Pay for Investors
Far more often than not, a fund fueled by fear takes you and your money down a dark path to nowhere.
Would you trust a steakhouse with a vegan grillmeister? Well, some managers of bond mutual funds find bonds so unappetizing that they have positioned their funds so that they boast a negative duration—meaning that these funds should make money when interest rates rise. That’s something most bond funds would be hard-pressed to do because bond prices move in the opposite direction of rates. I’m not talking about funds that are programmed to deliver, say, two times the inverse of the return of Treasury bonds. Those are automatons designed for investors (I use the word loosely) who are making a short-term call on interest rates.
An actively managed bond fund with a negative duration is another matter. For such funds to achieve their objectives, the managers must juggle piles of derivatives, such as interest-rate swaps and bond futures. Such funds typically yield little, nail you with high fees and turn over their portfolios rapidly, which can cause tax troubles if you’re investing in a regular account.
But my main objection is that these funds aren’t just cautious, or bearish in a thoughtful sense. They are flat-out fearful. And far more often than not, a fund fueled by fear takes you and your money down a dark path to nowhere.
I found 15 actively managed bond funds with average durations below zero. Most label themselves as “flexible” or “unconstrained,” which essentially means that they can invest in any kind of bond the managers fancy and, of course, that they can bet on rates rising by going negative with their duration.
Being unconstrained doesn’t necessarily mean a fund has a negative duration, however. For example, Metropolitan West Unconstrained Bond (symbol MWCRX), a member of the Kiplinger 25, has an average duration of one year and yields 1.6%. The fund has generated positive total returns in 13 of 14 quarters since its launch in 2011 and earned 2.5% over the past year through March 31. Its expense ratio of 0.99% is a bit higher than we’d like, but it’s not egregious.
But the records of unconstrained bond funds with negative durations have been pitiful—no surprise, given that rates have confounded many forecasters and continued to fall. Federated Unconstrained Bond A (FUNAX) is typical. With an average duration of negative 3.8 years and 1.18% in expenses, it lost money in 2013 and 2014 and dropped 3.4% in the first quarter of 2015. Scout Unconstrained Bond (SUBFX) has a decent expense ratio of 0.78% annually, and it got off to a fast start, returning 22.8% in 2012. But with a duration of minus 3.1 years, it has lost money for five straight quarters.
Surprising results. Moreover, it turns out that even if rates rise, a fund with a negative duration may not fare well. Bond specialists at Columbia Threadneedle Investments (formerly Columbia Funds) have studied the negative-duration math in detail, and they’ve found that rates would have to explode by much more than they had fallen previously to compensate you for the forgone income and high costs. “The only thing certain about employing negative duration for a long time is that you can expect a negative total return for a long time,” says Gene Tannuzzo, a senior portfolio manager at Columbia.
Tannuzzo expects rates to rise over the next year, but plenty of other bond gurus see rates holding steady or even falling more. My fellow Kiplinger’s columnist Jim Glassman recently opined that the 10-year Treasury could drop to 1%, from 1.9%). In sum, negative-duration funds smell like another fund-industry concoction whose time has not and never will come. Like the cauliflower chop. Or the Tofurky T-bone.