If interest rates are expected to increase, what should fund managers consider doing?

When interest rates are expected to increase, fund managers typically consider shortening the duration of their portfolios. Duration is a measure of a bond's sensitivity to changes in interest rates; the longer the duration, the greater the potential impact of rising rates on the bond's price.

When interest rates rise, the prices of existing bonds typically fall because new bonds are issued with higher yields. If a fund has a longer duration, it means that the bonds within the fund have a longer average time until maturity and are more affected by these interest rate changes, leading to potentially greater losses. By shortening the duration, fund managers can reduce the portfolio’s exposure to rising interest rates, thereby mitigating the risk of declining bond prices.

In contrast, increasing duration would expose the portfolio to more risk in a rising interest rate environment, while maintaining the current duration might not adequately address the heightened risk posed by expected rate increases. Diversifying asset allocation, while generally beneficial for risk management, does not specifically address the effects of rising interest rates on bond portfolios.