Morningstar Magazine - August/September 2017 - 24

Dispatches

data. Price competition was stronger in the
fee-based channel over the period. For example,
the average fee-based Canadian Equity
management expense ratio fell 7 basis points from
2011-16, versus a 3-basis-point decline for the
average commission-based fund in the category.
Without embedded commissions to attract
assets, fund managers compete, at least in part,
on cost. Removing financial incentives to favor
some funds over others encourages advisors
to focus on investment quality, of which cost is an
important indicator. This result is unambiguously
good for fundholders: Lower management fees
mean better returns for investors.
Proponents of embedded commissions often
characterize the commissions as fees for advice.
In most cases, however, these commissions are
fees paid by asset managers in exchange for funds
sold, not for advice. Under the embeddedcompensation model, investors receive varying
levels of service but pay a single, set price. Costs
may be transparent but what investors get in
return is not. Unbundling administrative and
operational fees makes the cost of advice explicit.
We anticipate that greater transparency will
require advisors to offer services commensurate
with the fees they charge.
Some have argued that discontinuing embedded
commissions risks leaving investors who have
relatively small balances without access to advice.
But rather than abandoning or de-emphasizing
these investors, we anticipate that technological
innovations in advice, commonly referred
to as robo-advisors, will serve this segment. We
view the rise of digital advice solutions as positive
for investors, as these solutions democratize
sophisticated asset-allocation models that had
been available only to large institutions.
By inducing competition and lowering costs,
improving transparency and accountability,
and driving technological innovation, Morningstar
believes investors will be well-served
by discontinuing embedded commissions.
Christopher Davis is a senior manager research analyst,
equity strategies with Morningstar Research Services.
Aron Szapiro is director of policy research with Morningstar
Research Services.

Morningstar August/September 2017

Making Sense of
Strategic Bond Funds

market embedded in conventional bond
funds can often provide the single most effective
portfolio ballast when market shocks lead
to extreme correlations among other bond and
equity market sectors.

GREATER EUROPE

United Kingdom

Fueled by a hunt for yield and anxiety over rising
rates, the flexible bond fund space took off after
the financial crisis. These funds promise to
insulate bond-fund investors from traditional bondmarket interest-rate risk while providing returns
at least in line with core bond funds. They are
generally conceived as "go-anywhere" bond funds
with broad flexibility to invest across sectors,
quality strata, and interest-rate exposures, and to
use derivatives liberally. Flexible bond funds fall
under two camps: multisector, income-oriented
bond funds; and unconstrained (including absolute
return) bond funds. While several funds in the
first group have been around since before the
global financial crisis, the latter group has been a
post-crisis phenomenon and has contributed
to the explosive growth of the flexible bond sector.
In a June 5 white paper titled "Does It Make Sense
to Hold Strategic Bond Funds in Your Portfolio?,"
Morningstar evaluated funds in the global
flexible bond Morningstar Category and the UK
Investment Association £ Strategic Bond sector. In
general, these funds suggest that investors
can enjoy returns commensurate with core
bond funds, sidestep interest-rate sensitivity while
doing so, and avoid losses given the use of
absolute return strategies. Such claims belie the
difficulty in capitalizing on unconstrained
strategies to source alpha and simultaneously
avoid market sell-offs. Over the past five years,
flexible bond portfolios have generally exchanged
interest-rate risk for some other type of risk,
whether high-yield corporate, emerging-markets
debt, structured credit, or currency risk.
We found that high correlations to credit-sensitive
sectors and equity markets reduce the appeal of
funds in this sector. As a ballast to counter equity
market turbulence, flexible bond funds are
generally a poor substitute for conventional
bond funds. Sensitivity to the government-bond

Flexible bond funds also face challenges from
trends toward tighter regulations governing the
use of derivatives, and the difficulty of generating
sufficient returns to overcome high expenses,
particularly to the degree that the global
bond market's low-yield environment persists.
As fund companies have rushed to capitalize
on the flexible bond trend, often positioning these
strategies as the ultimate showcase for active
management, investors have wound up taking
substantial manager risk. Many managers
are relatively new to such flexible investing, and
thus run the risk of stepping beyond their
circles of competence.
So far, the overall category has struggled to deliver
on its contradictory set of promises. A skeptical
eye is warranted when considering a flexible bond
fund as part of an overall portfolio plan.
Ashis Dash is associate director, fixed-income strategies,
manager research with Morningstar in the U.K.

Advantages, Limits of
Low-Volatility Strategies
GREATER EUROPE

France
Low-volatility strategies have gained traction
among equity investors since the global financial
crisis, and the eurozone debt crisis profoundly
shifted risk appetites. At the end of 2016, we
identified 89 low-volatility funds in Europe, double
the number available five years ago. These
funds have amassed substantial assets. In Europe,
we estimate that they have racked up EUR 27
billion of net flows since 2012, growing to EUR 40
billion by the end of 2016, with 15% of those assets
in exchange-traded funds. These flows have been

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017