By David Snowball

This fund is now the Carillon Reams Unconstrained Bond Fund.

Objective and Strategy

The fund seeks to maximize total return consistent with the preservation of capital.  The fund can invest in almost any sort of fixed-income instrument, though as a practical matter their international investments are quite limited.  The fund’s maturity will not normally exceed eight years, but they maintain the option of going longer in some markets and even achieving a negative duration (effectively shorting the bond market) in others.  They can use derivative instruments, such as options, futures contracts (including interest rate futures contracts), currency forwards or swap agreements (including credit default swaps) to enhance returns, increase liquidity and/or gain exposure to particular areas of the market.  Because they sell a security when it approaches fair market value, this may be a relatively high turnover fund.

Adviser

Scout Investments, Inc. Scout is a wholly-owned subsidiary of UMB Financial, both are located in Kansas City, Missouri. Scout advises the eleven Scout funds. As of June 30, 2012, assets under the management of the Advisor were approximately $22.37 billion.  Scout’s four fixed-income funds are managed by its Reams Asset Management division, including Low-Duration Bond (SCLDX), Core Bond (SCCYX, four stars) and Core Plus Bond (SCPZX, rated five star/Silver by Morningstar, as of October 2012).

Manager

Mark M. Egan is the lead portfolio manager of the Fixed Income Funds. Thomas M. Fink, Todd C. Thompson and Stephen T. Vincent are co-portfolio managers of the Fixed Income Funds. Mr. Egan joined the Advisor on November 30, 2010. He oversees the entire fixed income division of the Advisor, Reams Asset Management, and retains oversight over all investment decisions. Mr. Egan was a portfolio manager of Reams Asset Management Company, LLC (“Reams”) from April 1994 until November 2010 and was a portfolio manager of Reams Asset Management Company, Inc. from June 1990 until March 1994. Mr. Egan was a portfolio manager of National Investment Services until May 1990.

Management’s Stake in the Fund

Messrs. Egan, Fink and Thompson have each invested over $1,000,000 in the fund.  Mr. Vincent has between $10,000 – 50,000 in it.

Opening date

September 29, 2011.

Minimum investment

$1,000 for regular accounts, reduced to $100 for IRAs or accounts with AIPs.

Expense ratio

0.99%, after waivers, on assets of $45 million (as of October 2012).

Comments

There are 6850 funds of all kinds in Morningstar’s database.  Of those, precisely 117 have a better one-year record than Scout Unconstrained Bond.

There are 1134 fixed-income funds in Morningstar’s database.  Of those, precisely five have a better one-year record.

98.3% of all funds trail Scout Unconstrained between November 1, 2011 and October 30, 2012.  99.6% of all fixed-income funds trailed Scout for the same period.

Surprised?  You might not be if you knew the record of the management team that runs Scout Unconstrained.  Mark Egan and his team from Reams Asset Management have been investing money using this strategy since 1998.  Their audited performance for the private accounts (about $231 million worth of them) is stunningly better than the records of the most renowned bond fund managers.  The funds below represent the work of the three best-known bond managers (Jeff Gundlach at DoubleLine, Bill Gross at PIMCO, Dan Fuss at Loomis) plus the performance of the Gold-rated funds in Morningstar’s two most-flexible categories: multi-sector and world.

Annualized Performance Ending September 30, 2012

You’ll notice that the performance of Scout Unconstrained does not equal the performance of the Unconstrained Composite.  The difference is that the team bought, in the private accounts, deeply distressed securities in the 2008 panic and they’re now harvesting the rewards of those purchases.  Since the fund didn’t exist, its investors don’t have the benefit of that exposure. Clark Holland, a Portfolio Analyst on the Fund, reports that, “We strive to invest the separate accounts and the mutual fund as closely as possible so returns should be similar going forward.”

Just because I’m a cautious person, I also screened all bond funds against the trailing record of the Unconstrained Bond composite, looking for close competitors.  There were none.

But I’m not sure why.  The team’s strategy is deceptively simple.  Find where the best values are, then buy them.  The Reams website posits this process:

STEP 1: Determine whether the bond market is cheap or expensive by comparing the current real interest rate to historical rates.

STEP 2: Focus on sectors offering relative value and select securities offering the highest risk‐adjusted return.

STEP 3: Continually measure and control exposure to security‐ and portfolio‐level risks.

It looks like the fund benefits from the combination of two factors: boldness and caution.

It’s clear that the managers have sufficient confidence in their judgment to act when other hesitate.  Their 2012 Annual Report cites one such instance:

A contribution to performance in the asset-backed securities (ABS) sector can be traced to our second lien or home equity holdings, which strongly outperformed.  We purchased these securities at an extreme discount after the 2008-2009 financial crisis, when defaults on home equity loans were high. Since then, default rates declined, the perceived risk of owning these securities lessened, and the prices of the securities have risen sharply.

As you comb through the fund’s reports, you find discussions of “airline enhanced equipment trust certificates” and the successful exploitation of mispricing in the derivatives market:

High-yield index swaps (CDX) such as those we own, which represent groups of credit default swaps (CDS), usually are priced similarly to high-yield cash bonds. Due to somewhat technical reasons, a price gap opened, in the second quarter of this year, between the price of high-yield CDX index swaps and high-yield cash bonds .We took advantage of the price gap to buy the CDX index swap at an attractive price and captured a nice return when pricing trended back toward a more normal level.

One simple and bold decision was to have zero long exposure to Treasuries; their peers average 35%.   As with RiverPark Short Term High Yield, the fact that their strategy (separate accounts plus the fund) has attracted a relatively small amount of investment, they’re able to drive performance with a series of relatively small, profitable trades that larger funds might need to skip over.

At the same time, you get a sense of intense risk-consciousness.  Cautious about rising interest rates, the managers expect to maintain a shorter average duration as they look for potential investments. In his October 3, 2012 letter to investors, Mr. Egan lays out his sense of how the market is evolving and how his team will respond:

What to do? Recognize the reality of a challenging environment, focus on your realistic goals as an investor, and be ready to seize opportunities as they arise.  A well-known investor recently opined as to the death of equity as an asset class.  Our take is the death of static risk allocations, or even what constitutes risk, along with buy and hold investing.  The successful investor will be aware of the challenges we face as a society, understand the efficacy or lack of it in the various (mostly political) solutions prescribed, and allow volatility, and the inevitable mispricing that will result, to be your guide. Flexibility and nimbleness will be required.  For our part, we have positioned accounts in a cautious, conservative stance as the cost of doing so has rapidly declined. We may be early and we may forgo some modest gains in risk assets, but it is both appropriate and in keeping with the style that has generated returns well in excess of our peers over most time periods.

Bottom Line

You need to approach any “too good to be true” investment with care and diligence.  The track record behind SUBFX, which is splendid and carefully documented, was earned in a different sort of investment vehicle.  As assets grow, the fund’s opportunity set will change and, possibly, narrow.  That said, the managers have successfully invested substantial sums via this strategy for nearly 15 years; the fact that they’ve placed millions of their own dollars at risk represents a very serious endorsement.

Fund website

Scout Unconstrained Bond.  Mr. Egan also wrote a very good white paper entitled “Fixed Income: The Search for Total Returns in Volatile Markets” (March 2012).  If you’re intrigued by the fund, you’ll get a better sense of the managers’ approach.  Even if you’re not, you might well benefit from their discussion of “the growing risks of not taking risks.”

Fact Sheet

© Mutual Fund Observer, 2012. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact us.