In this fund, you will find a new definition of pain

How's your bond mutual fund doing this year? Odds are good that if it isn't a Treasury fund, its underperforming the Lehman Aggregate. 86% of funds are behind that index though 9/30 according to Morningstar.

There are basically two things that have gone wrong for managers in 2007. One is underweighting Treasuries. And as I've written before, almost all managers are underweight Treasuries, even those who are bearish on credit. Managers are much more willing to own higher quality corporates and/or MBS if they're bearish on credit.

The reason is that overweighting Treasuries will invariably result in a portfolio with a lower yield than its benchmark. If you add the manager's fee with a weaker portfolio yield, the result is that the manager is starting the relative performance game from behind. In order to wind up outperforming when you have a lower yield than your benchmark, your bets have to work out quickly.

For example, assume that you are overweight Treasuries because you expect wider credit spreads. Say a 20% overweight costs you 25bps in yield versus the index. If your portfolio duration is 5 and the Treasuries in the index is 20% (about the same as the Aggregate) then the rest of the portfolio has to widen by 25bps in one year in order for you to break even. 25bps isn't a huge move, but it isn't a small one either.

If, however, it takes two years for the credit widening to occur, then you really need 50bps of widening, because you've suffered through the 25bps of negative carry for two years.

Alternatively, bearish managers could underweight Treasuries while simultaneously underweighting Baa-rated bonds. Normally one would expect Baa's to underperform Aa bonds in a credit widening. So the manager who overweights Aa at the expense of both Treasuries and Baa probably still outperforms when spreads widen. Plus this kind of strategy probably doesn't require a give up in income. So a manager following this strategy can be mildly bearish on credit for an extended period of time without having negative carry eat away at returns.

Given that nothing has worked this year other than owning Treasuries, the second strategy proved to be a miserable failure in 2007. Hence why 90% of managers are behind the Agg. For some managers, the higher quality trade still might be of some use to us. I'd say the odds are good that as time passes, we'll move toward a more normal relationship between high quality assets and Treasuries. So many of the underperforming managers will turn into better performers in the near future.

Then there are the fund managers who got mixed up in subprime bonds.

First there are the funds that dabbled in mostly Aaa-rated subprime pools, like Western Asset Core Bond. This fund finds itself in the bottom quartile of bond funds so far in 2007 owing in part to its high-yield exposure, but more so to its small subprime position. Its trailing the Lehman Aggregate by 190bps through 9/30.

But if you think that's bad, consider the case of the Regions Morgan Keegan Select Intermediate Bond Fund. Ostensibly this is intended to be a "normal" investment-grade bond fund. And yet its somehow lost over 21% so far in 2007. And you thought the Global Alpha fund was having a bad year! At least investing in a hedge fund you knew you were taking risk. This was supposed to be an investment grade bond fund. You know, where you don't take a lot of risk? You know, the safe part of your portfolio?

And here is the thing. As far as I can tell, the portfolio manager, Jim Kelsoe, hasn't been fired yet. What are they waiting for? This guy is truly having one of the worst years in the history of investment grade bond managers. I mean ever. I have never heard of anyone doing this badly with an all investment grade, no leverage fund. Seriously. Oh maybe Jim's stellar letter to investors convinced Morgan Keegan to keep him around. Read it for yourself. See if that would make you feel any better about losing 21% on your fund.

-21%! I just can't get over it. -21% and you still have your job! Check out this picture on the Regions website. Do you think this woman just read her statement saying she's lost 21% on her bond fund? I think she kind of has that sort of "holy shit I'm completely screwed" smirk. Like you are so shocked you don't know whether to laugh or cry. That photo was a good selection by the Regions folks.

Here is the sad part. There are probably investors who don't realize they've lost this much money yet. Mutual fund statements usually come every quarter or even every 6-months if there is no activity. People would be just now getting their September 30 statements. How would you like to see that? You're bond fund is bumping along with a $10ish NAV then all of a sudden its $7. Oh and the manager? Not fired, so don't worry. The same fine team who brought you all these losses will be back in on Monday, firing up their Bloombergs, ready to work for you. Oh and we went ahead and charged our expense ratio for this year directly out of the fund. Wouldn't want to trouble you with writing a check!

Posted by TDDG at 7:41 PM