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Fund Spy

PIMCO, JP Morgan, and Eaton Vance: Unconstrained

Three firms take an early lead in an exploding corner of the fund market.

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If you haven't heard of so-called "unconstrained" bond funds, you will. It's one of the hottest segments of today's mutual fund market: Morningstar estimates put the group's growth over the past 12 months at more than 260%, with its 20 or so funds bulging to roughly $44.5 billion at the end of February 2011.

Despite their modest number and only recent surge of popularity, the central idea behind unconstrained bond funds, some of which are also conceived as absolute-return bond funds, isn't new. The name is typically used to describe portfolios that (1) use a cashlike benchmark such as LIBOR, (2) can invest both long and short in the bonds and derivatives of nearly any fixed-income sector with wide limits on their weightings, and (3) have a very wide berth within which to manage interest-rate sensitivity.

Those Were the Days ...
The embrace of that last feature signals a nod to the old days. Although few funds advertised the same terminology, it was common in the 1980s and much of the 1990s for bond-fund managers to make big bets on the direction of interest rates, dramatically shortening duration (a measure of rate sensitivity), or extending it out to several years, with little regard to the anchor of a benchmark. Some employed considerable flexibility to invest across sectors as well. That began to change in the mid-1990s as most managers began adopting stringent, institutional practices, including the use of tight duration constraints and stricter attention to benchmarks. After some shocking trouble prior to 1995, for example, Fidelity's bond funds began to keep their funds' interest-rate sensitivities right on top of their respective indexes' and stripped risky allocations from funds that investors otherwise expected to be docile.

Eric Jacobson has a position in the following securities mentioned above: PTTRX. Find out about Morningstar’s editorial policies.