In USA too Funds Leap Beyond Their Benchmarks


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In USA too Funds Leap Beyond Their Benchmarks

In a world of shrinking bond yields, many mutual funds have found a way to make themselves look better.

Their secret: Invest in riskier bonds but continue to measure their performance against benchmarks composed of safer investments.

At least 187 bond funds, including those run by big asset managers such as Allianz SE's ALV.XE -0.78% Pacific Investment Management Co., Oppenheimer Funds Inc. and Putnam Investments, are handily beating the benchmarks against which they compare themselves, according to an analysis by investment-research firm Morningstar Inc. MORN +0.52% for The Wall Street Journal.

Many of them have done so by investing in high-yield corporate bonds, mortgage-backed securities and emerging-market debt, among other securities, according to Morningstar.

Of course, all active fund managers try to beat the benchmark. But concerns can arise when fund managers invest in bonds or other instruments in a proportion that is far off the benchmark. That makes it all the more important, experts say, for investors to keep tabs on their funds' holdings.


Jon Krause
Funds that stretch for higher yields could be at risk of steep losses if the market turns. In 2008, about 40 funds that held large positions in mortgage-backed securities and derivatives outside their benchmarks lost 10% or more, according to Morningstar.

"If they had been more closely tracking the index, a lot of those losses wouldn't have happened," said Eric Jacobson, Morningstar's director of fixed-income fund research.

Benchmarks are the main tool investors use to measure mutual funds' performance. But bond funds are free to choose—and change—their benchmarks.

The Securities and Exchange Commission requires funds to include in their annual reports a chart comparing their performance over a 10-year period with that of an "appropriate broad-based" securities benchmark. But there are no specific requirements, said SEC spokesman John Nester.


Bond mutual funds have boosted their performance this year, in part by deviating from the benchmark indexes they are supposed to resemble. Click on column headers to sort.


Fund prospectuses typically warn investors that managers reserve the right to invest outside their benchmarks as conditions warrant. At the same time, in marketing materials, funds often compare themselves against their benchmark as evidence of strong performance.

Lately, bond funds have been straying more than usual. The "tracking error," the term Morningstar uses for the amount that bond funds veer from their benchmarks, has averaged 2.20% for the 12 months through Aug. 31. (A reading of zero signifies perfect alignment with the benchmark.) The gap was 1.95% during the same period in 2011, according to Morningstar.

In the five years before the financial crisis, the deviation averaged 1.37%.

On average, bond funds beat their benchmarks in the year ended Aug. 31 by about 1 percentage point, according to Morningstar. During the corresponding period in 2011, they trailed their benchmarks by an average of half a point.

To be sure, other factors besides deviation from the benchmark can affect fund performance, such as the timing of bond purchases and sales. And not all funds that stray are rewarded for their daring: 102 of the funds Morningstar flagged had returns that lagged behind or matched their benchmark.

Still, many funds are holding much riskier bonds than their benchmark indexes would suggest—and for the moment are being rewarded.

Putnam Investments' Diversified Income Trust fund, with $3.4 billion in assets under management, has returned 9.4% in 2012, easily beating its benchmark, the Barclays U.S. Aggregate Bond Index, which has returned 3.5%, according to Morningstar.

Almost three quarters of the Barclays index is devoted to low-yielding U.S. Treasurys and securities issued or backed by U.S. government agencies. The Putnam fund doesn't hold any of those types of bonds.

Instead, the fund has 30% of its holdings in high-yield corporate bonds, 17% in emerging-market bonds from countries like Russia and Venezuela, and 16% in non-agency mortgage-backed securities.

Bill Kohli, co-head of fixed income at Putnam and manager of Putnam Diversified Income Trust fund, said the fund makes it clear in its marketing material that it invests in a "range of investment opportunities" including emerging-market debt, high-yield bonds and mortgage-backed securities.

Oppenheimer Global Strategic Income Fund, with $8.7 billion in assets, has seen its tracking error jump from 6.9% to 7.5% in the past year, according to Morningstar. It holds no U.S. Treasurys, and has 30% invested in high-yield bonds and 32% invested in emerging-market debt, according to the company.

The fund has beaten its benchmark, the Barclays U.S. Aggregate Bond Index, by about 7 percentage points this year.


Art Steinmetz, Oppenheimer's chief investment officer, said other indexes might be a more appropriate performance gauge at the moment. But he said the fund frequently changes its holdings, as allowed in its investment mandate, and that it wouldn't make sense to change its benchmark often.

Pimco Total Return, the world's largest bond fund with $273 billion in assets under management, also used the Barclays index as its benchmark. Its tracking error rose to 3.62% at the end of August, compared with 2.75% last year and 1.55% in 2010, according to Morningstar.

Pimco co-chief investment officer and founder Bill Gross has slashed the fund's holdings in U.S. Treasurys to 21% of the portfolio in August, compared with 33% at the end of July. Half of the portfolio is held in a mix of non-agency and agency mortgages. The fund has returned 8.7% so far this year. Pimco declined to comment.

Jacob Wolkowitz, an investment manager at Minnesota-based Accredited Investors, which has about $1 billion in assets under management, said he recently shopped for new bond funds to invest client money.

In each call with fund managers, he said, he brought up the issue of their benchmark. Mr. Wolkowitz said six or seven years ago, bond fund benchmarks better reflected a fund's investments.



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