With the Federal Reserve expected by many to begin increasing interest rates next month, investors will be looking to the managers of unconstrained bond funds for protection.

But figuring out what the managers of these "go anywhere funds" are doing can give investors whiplash: managers are allowed to buy whatever securities they want whenever they want, and have carte blanche to do such things as sell Treasury bonds short and stuff their portfolios with derivatives.

On top of that, the average unconstrained bond fund has 198 percent annual turnover, according to Lipper, meaning that the securities in the funds in March could have been completely swapped out by September.

Understanding the mechanics of these funds has gotten so difficult that even analysts at fund research shops Morningstar and Lipper can't get a handle on what these portfolios are doing, analysts told Reuters.

"A lot of promises have been made about unconstrained fixed- income approaches and those promises have been a lot more powerful than the level of disclosure that the funds provide," said Michael Herbst, an analyst at Chicago-based Morningstar.   

Fund companies say that the whole reason investors choose their funds is because they don’t want to be bothered with the nuances of what the managers are doing.

"When you switch over to an unconstrained portfolio mandate you are lowering your interest rate risk, but taking on manager risk," said Anne Walsh, assistant chief investment officer for fixed income at Guggenheim Investments and co-manager of the $3.6 billion Guggenheim Macro Opportunities Fund.

Duration Bets

If the past few months are an indication, investors are right to be concerned. Nine of the 10 largest unconstrained bond funds underperformed the Barclays Aggregate Bond Index in the 12 months ending June 30, as managers bet wrong by positioning their portfolios for the Fed to raise rates last year, according to Lipper.

Unlike most "core" or intermediate-term bond portfolios, unconstrained bond funds can have long, short or negative duration. Duration is a measure of a bond's sensitivity to interest rate fluctuations, and going shorter or negative duration is an investment strategy pursued when rates are expected to rise.

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