Our team at Charles Schwab Investment Management (CSIM) has a lot of meetings with bond fund managers. Besides managing our own funds, we evaluate external bond managers as potential sub-advisers for our target-date funds (TDFs) and collective trust funds. In performing those evaluations, quite a bit of institutional knowledge is generated.
In our experience, the way bond managers speak provides insight into their true thinking, underlying skills and biases. When we look for bond managers as sub-advisers, there are things we like to hear, but there are also things managers say that immediately trigger our alarms.
Below are three common examples. While none of them is a guarantee that something is wrong, we believe they should be seen as significant red flags if you hear them in an investment review or when you are seeking a new bond fund for your plan.
“It’s ‘money-good.’ We’ll just hold it to maturity.”
As soon as a bond manager defends a poorly performing position by arguing that the current price is irrelevant since the bond will eventually mature, we’re highly dubious. There’s an inclination among some bond managers to hold onto a deteriorating or underwater position with the hope that, in time, the bond will mature. Hope is not an investment strategy, and the impulse to wait for a payoff at maturity can, in fact, be a trap.
Unlike equity managers, bond managers are particularly susceptible to holding a losing position, because the security “promises” a return of principal at a future maturity date. If, for example, a manager buys a corporate bond with an attractive yield that then starts to underperform, he may be tempted to just hold onto it and ride out the underperformance until maturity. This is an incredibly dangerous approach to investing. Holding onto a bond that didn’t work out as anticipated could make a bad situation much worse. There is a serious risk of default, and the investor may never see his money on the maturity date. Remember, the only security that is truly “money-good”—that is guaranteed to pay out its full face value upon reaching maturity—is a U.S. Treasury.
If a manager’s instincts often lead him to simply wait out bad positions, it raises significant questions about the approach to risk management. We recommend level-setting conversations with managers to identify their approach in situations when their strategy goes awry. We seek to understand how they manage through these situations, including how they avoid defaults and liquidity issues to help investors circumnavigate worst-case scenarios. In the end, we want to ensure that bond managers have the wisdom to recognize when they are wrong and take appropriate action.
“Pardon my jargon.”
Albert Einstein famously said, “If you can’t explain it to a 6-year-old, you don’t understand it, yourself.”
Bond managers who speak in overly complex or opaque terms are often either masking underlying issues or they don’t have a strong fundamental understanding of the topic themselves. So if you ever find yourself remaining confused by what a bond manager is telling you, that’s a red flag.
In particular, if the conversation turns especially muddled and confusing during periods of underperformance, that’s an even bigger red flag. There is never a greater need for forthcoming dialogue and maximum transparency than during a period of underperformance. And, yet, that can be when it is in shortest supply.
We look for plain-spoken, transparent managers at all times. Managers who obfuscate cast doubt on their own credibility and willingness to take responsibility for their poor decisions.
“The model says so.”
When a bond manager is overly reliant on analytics to tell him what the risks are, he is likely missing the bigger picture. Models can be great tools, but their value relies entirely on the quality of their inputs and the interpretation of their outputs. Models themselves don’t predict the future, and they’re based on historical patterns and relationships. It’s important to remember that those patterns often break down.
To that point, bond managers can be prone to rely on complex analytics in order to gauge the magnitude of their risk exposures. For example, the model may show a portfolio’s underlying corporate-sector exposure to be the same as the index. Yet, the portfolio’s corporate holdings may be entirely in lower-quality or higher-yielding securities, which have a far greater degree of default risk than the holdings of the index. Thus, even if the corporate allocations appear the same, the composition of those allocations can cause very different results for the investor. In times of market duress, the portfolio’s actual results could differ significantly from what the model predicts.
So, be wary of the professional who overly relies on his model—whether, for example, quantitative analysis or a strategy based on backward-looking correlations—to manage real-world risks.
Most of the conversations we have with bond managers are alarm-free, as they should be. But, as you conduct regular plan investment reviews, it’s good to have an alarm system in place just in case. If you encounter any of the “watch out” phrases described above, it’s time to dig deeper, pursue transparency and require a well-reasoned and well-articulated strategy.
The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction in terms of his or her own particular situation.