Market Insider

Hedge fund strategies meet bond mutual funds

What is unconstrained investing?

For all the talk and buzz around indexes, or passive investing, the next big thing for bond mutual fund investors may be strategies that are the exact opposite.

The rapid growth of "unconstrained bond funds" has been thrust into investor spotlight given last Friday's stunning news that PIMCO Founder and star fund manager Bill Gross was leaving his firm to join competing fund manager Janus Capital.

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One of Gross' key roles at Janus will be to manage the firm's recently launched Global Unconstrained Bond Fund. The fund was launched on May 27, 2014, and had just around $13 million worth of assets at the end of August.

However, Janus is looking to take a deeper dive into managing bond funds, and the addition of Gross is meant to help bring all-star name recognition to the fund and firm overall.

For many investors and advisors, unconstrained bond funds have become a bigger part of the investing landscape. Simply put, these types of bond funds seek to invest money in bond, interest rate, currency and related securities regardless of where they're located.

Read MoreGross exit not about investing strategy: Pimco CEO

Think of it like a hedge fund that invests in the bigger picture, or macro themes, looking to capitalize on opportunities as they arise. Global unconstrained bond funds are prime examples of active fund management, where managers use their expertise to find the best investable options.

Traders take orders in the Standard & Poor's 500 stock index options pit at the Chicago Board Options Exchange (CBOE) in Chicago, Illinois.
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Unlike many bond mutual and exchange traded funds that are linked to an index, unconstrained bond funds are held to no specific index and rely on management expertise to generate investor profits. It is because of this type of latitude that they're known as "go anywhere" funds.

The active management and "go anywhere" philosophy is further reinforced to potential investors in fund marketing materials and prospectuses.

Read MoreBill Gross exit not about investing strategy: Pimco CEO

For example, PIMCO's Unconstrained Bond Fund says that it is an absolute return-oriented fund that "takes a flexible approach to capturing global opportunities and managing risk." It further adds that "by removing benchmark constraints, the fund gains significant latitude to tap into credit, interest rate, volatility and currency opportunities across global sectors and regions."

A check on the Janus Global Unconstrained Bond Fund marketing materials says that it is an "opportunistic bond fund seeks to achieve positive total returns in diverse market environments over a full market cycle by focusing on managing overall portfolio duration, credit risk and volatility," further adding that it is an "unconstrained nontraditional bond holding that opportunistically manages duration, interest-rate, sector and geographic exposure in an effort to maximize total returns."

Gross anatomy: Ripple effects

Not all of these types of bond fund strategies use the word "unconstrained" in their names. Two of the biggest funds of this type are Goldman Sachs' Strategic Income Fund with $25 billion in assets, as well as BlackRock's Strategic Income Opportunities Fund with about $20 billion in assets.

According to Morningstar Senior Research Analyst Michelle Swartzertruber, the annualized three-year performance figures of some of the biggest non-traditional bond funds have been generally positive.

Read MoreBill Gross is NOT crazy: Ron Insana

PIMCO's Unconstrained Bond Fund has posted an annualized return of around 3 percent during that time through the end of last month.

The JPMorgan Strategic Income Opportunities Fund has posted an annualized return of around 4 percent. The BlackRock Strategic Income Opportunities Fund has an annualized return of around 5 percent. The Goldman Sachs Strategic Income Fund has posted an annualized return of nearly 6 percent.

Meanwhile, the Vanguard Total Bond Market Index Fund had annualized returns of around 3 percent, and the PIMCO Total Return Fund actually gained a little over 4 percent. While the largest non-traditional bond funds tracked by Morningstar manage around $25 billion, the PIMCO Total Return Fund had around $220 billion in assets and the Vanguard Total Bond Market Index Fund had around $121 billion.

However, these unconstrained, or non-traditional, bond funds have been garnering assets, as opposed to other parts of the bond fund industry that are grappling with investor redemptions/outflows.

One of the big reasons why investors are increasingly interested in these types of funds is the current and anticipated future interest rate environment.

Low interest rates have led investors who seek income generating assets in the bond market to go beyond the Treasury and mortgage bond market, towards things like emerging market sovereign, as well as corporate debt. Both are places that unconstrained bond funds can go without fear of sticking to an established index.

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For those investors that believe that globally low interest rates will at some point normalize and head higher, many bond investors with index related holdings could see a trend of lower bond prices as those interest rates rise. Unconstrained bond funds are seen by some as a way to avoid much of the downside in a rising rate environment, given that managers don't have to hold the same types of instruments as underlying indices. Of course, the generation of "absolute returns," or the avoidance of losses is all contingent on how well the fund manager can predict and navigate markets.

Gross' departure from PIMCO for Janus also highlights an interesting view on how each fund management company wants to proceed with managing assets.

For Janus, it's counting on the name recognition that a manager like Bill Gross can bring to the company. Janus will be using Gross' reputation as a way to garner assets for its fund offerings.

PIMCO, on the other hand, is relying less on the name brand of one rock star manager, and touting the team approach that its company brings to the table. That team approach is a way to assure investors that just because one manager leaves, there will be continuity when it comes to investing style, and possibly future performance.

Now the question facing many financial advisors is…which is the preferred investing style? PIMCO hopes to keep clients from pulling assets from its unconstrained bond fund by touting its team of experts, while Janus is hoping to grow its $12 million unconstrained bond fund with the lure of investing with "bond king" Bill Gross.