For similar reasons, credit market volatility may also be higher in the period ahead. While many allocators properly observed the credit opportunities that arose amid the market disruptions of March 2020, many fixed income managers’ ability to move capital swiftly to capture the market mis-pricings was severely hampered by poor liquidity conditions. In such situations, unconstrained bond funds can act as the de facto “tactical asset allocator” for clients who may not otherwise be able to reallocate capital quickly and nimbly in response.
2. Benchmark-agnostic
To take full advantage of an unconstrained bond universe and truly diversify a client’s fixed income allocation, a manager must be able to access and evaluate a wide range of securities. By basing investment decisions on specific total-return opportunities instead of in relation to a benchmark, the manager is more likely to provide additional exposures not often held in client portfolios, including non-core asset classes that are “off the radar” of most investors. This greater variety of fixed income opportunities as compared to traditional benchmark-centric strategies typically translates to greater overall portfolio diversification.
Naturally, an unconstrained bond fund will tend to have higher realized tracking risk (TR) against the broad market indices than most traditional core strategies. Investors accustomed to gauging their fixed income allocations partly by adherence to preestablished TR ranges may initially find these higher TR levels to be unsettling. However, “unconstrained” does not have to mean “high risk,” despite the potential inclusion of a wide array of noncore positions. An unconstrained strategy encourages commonly sought-after investor outcomes (rather than benchmark-oriented investing), including capital preservation via multiple downside mitigation agents working in concert. In fact, we contend that higher TR can make an unconstrained approach a better complement to traditional fixed income strategies as a portfolio diversifier, while also enhancing total-return potential.
3. Absolute return “hybrid”
Most unconstrained bond strategies followed two distinctly different routes back when the fund universe was first created — toward either total-return or absolute return investing. This was a false dichotomy, in our view, because we believe unconstrained bond funds should seek to offer the best of both worlds.
Investors need exposure to longer-term strategic themes that have some degree of market beta in order to generate returns when yields are compressing. At the same time, absolute return strategies can serve an important purpose in minimizing portfolio downside during higher-volatility periods. Having both capabilities in one fund gives a manager increased flexibility as a macro cycle progresses. Earlier in the cycle, when yields and spreads are high, the manager can allocate more to strategic fixed income sectors and away from absolute return. Later in the cycle, when beta opportunities may be scarce, the manager can allocate away from strategic sectors in favor of absolute return.