I spent a quiet Saturday morning over a week ago reading on the couch, a welcome break after a turbulent week in the markets. Thinking about potential column topics, I reviewed my email inbox to capture the buzz from the prior week. Aside from market commentary, major trending items from my inbox included stories about the San Francisco Giants and 49ers, New England Patriots (I split my time between the East and West coast and have conflicting and sometimes confusing sporting loyalties!), and Russian brides (deeply sorry Svetlana, but I don’t think were destined to get married).

Following closely behind sports and brides in my inbox was stories about unconstrained bond funds, a better topic for this months column.

Unconstrained bond funds have been the shiny new toys of the bond world, surpassing $150 billion of assets as measured by the Morningstar nontraditional bond category. The departure of Bill Gross from PIMCO to manage an unconstrained bond fund at Janus triggered an outpouring of stories as well as renewed controversy about the merits of unconstrained bond strategies.

The Case for Unconstrained Bonds

The appeal of unconstrained bond funds is understandable. The shortcomings of most bond indexes, frustration with the low interest rate environment and fears of rising interest rates are all catalysts for investors to seek something else. Also not to be discounted is the attraction of a strategy that can go anywhere to seek investment returns.

As we’ve written in prior columns, we think that bond benchmarks reward bad behavior, benefiting those who issue the most debt. In good times, the shortcomings of bond indexes may be less apparent, but in bad times such as the European debt crisis, investors often suffer if an index is cluttered with credit from troubled issuers.

The most commonly used bond index is the Barclays U.S. Aggregate Bond Index. The AGG is dominated by U.S. government securities and with the U.S. still considered by most to be a creditworthy borrower, the AGG is generally considered to carry a limited amount of credit risk. However, the AGG carries significant interest rate risk. Consensus expectations are for rising interest rates, and many investors consequently want to reduce the risk interest rate sensitivity of their bond portfolio.

The theoretical appeal of an unconstrained bond fund is easy to understand. An unconstrained portfolio, in theory, can provide the flexibility necessary to avoid the worst bond sectors, and seek out the most attractive bond sectors while mitigating risk. Unconstrained funds can be long or short and rotate into and out of different sectors. Whats not to like?

What Could Go Wrong?

Providing so much flexibility isnt for the faint of heart. Flexibility can increase risks as well as rewards. Completing due diligence on unconstrained bond funds may be more challenging a process than doing so for conventional bond funds. As weve seen with liquid alternative funds, one unconstrained bond fund may be completely different from another, which can make it very difficult to compare one fund to another within the category. Some unconstrained bond funds may be designed to mitigate certain risks; others are seeking to elevate returns.

It is also important to understand when you are trading one risk for another, as is often the case today. Many unconstrained funds have significant investments in high-yield corporate bonds, which are more exposed to equity risk factors than to interest rate risk.

Lately, these funds also have high exposure to mortgage-backed securities, which have a number of unique risks, including pre-payment risk that increases as the economy improves due to increased housing turnover. In such cases, we think it’s important to understand and accept the risk trade-offs.

All of the above raises the question: what should investors think about before investing in unconstrained bond funds? There are three main issues to consider.

1) Portfolio Role

What is the role of bonds in the portfolio? Investors simply looking to align future cash-flow needs with current assets may be better off with a simple bond ladder. Investors considering unconstrained bond funds as a supplement to a core bond fund position should look at different criteria than investors using unconstrained bond funds as a replacement for a core bond holding.

2) Manager Capabilities

It is critical to understand the capabilities of the team managing the money. With great freedom comes great responsibility, and identifying whether the team is up to the task is an important element in the due diligence process. Identifying options across the fixed income landscape is challenging for fund management teams, requiring macroeconomic expertise, credit research for sovereign and corporate issuers, and specialized credit research for the mortgage- and asset-backed issuers.

In equities, we think that smaller, more nimble asset management teams are more likely to deliver sustainable outperformance. For unconstrained bonds, we think that bigger is often better, offering the depth, breadth and access necessary to capitalize on opportunities across the fixed income universe.

3) Fund Positioning

It is important to understand whether a funds positioning is tactical, as a function of the current environment, or is strategic or structural in nature. Many unconstrained funds have had significant concentrations in investment grade and high-yield corporate bonds, arguably because corporate bonds have been among the most attractive opportunities following the financial crisis.

Some firms will rotate away from corporate bonds when they become less attractive, while others may continue their focus on corporate bonds because their research capabilities are centered in the corporate bond arena.

Mr. Gross has his own professional and personal reasons to put all his eggs in an unconstrained bond basket. Before you do the same, consider what you are trying to get and what risks you may be taking on.