Double charging has reduced, while management of style exposure and their status as capital gains tax havens are attracting greater interest from advisers
Funds of funds are becoming increasingly popular within the investment management universe. This is apparent through the continued momentum in sales and the increasing number of funds available.
The reasons for this increase in popularity are in the main fairly straightforward. Investors have suffered over the last few years not only from a prolonged bear market but also from a volatility of investment performance not previously experienced.
Combined with the continued trend of investment company mergers and high-profile fund manager defections, this has hit confidence hard.
Under these conditions, there are now a number of challenges that advisers and their clients face when building a managed portfolio.
For the reasons already listed, it is now more important than ever to review portfolios constantly and have a thorough research process that identifies the effect of fund manager changes, provides a sufficiently high level of diversification of management styles and is actively managed to avoid high profile disappointments. The fund of funds approach is the ideal way to achieve this.
The last three years have been the most difficult in investment terms since the early 60s because this time round so many more investors have been affected.
While the bear market of the mid-1970s may come to mind, it is important to remember that at that point most private client investors were experienced to a certain degree or had their portfolios managed by professional investment managers.
This time around many new investors have been affected. Not only that but these new investors had made their own decisions based on a little knowledge and got used to significant annual returns on their capital. They benefited from the bull period in the stock market and are now scared after three years of pain.
These are the two ends of the investing spectrum. Experience shows that new investors generally enter the market towards the end of a bull market and on the back of spectacular gains (in this case through technology stocks).
One the reasons for the fall in the market was the bubble that had been created by investors anxious to find the double-digit returns they had seen through the period of high inflation. They failed to recognise that in lower inflationary periods, market returns will be less.
In the 1960s when inflation was at or around current levels for example, fund managers looked for returns between 7%-10% and clients were happy to accept this.
Another reason has been the degree of style change we have experienced which has created a greater degree of performance volatility than I have ever seen. There are now only a handful of funds and managers that have been consistently in the top half of their respective sectors over the last five years.
Add to this the economic factors of a global slowdown and you have a bear market. All these factors combined with changes in regulation have come to make the adviser's job even more difficult.
We look at funds of funds as one of the investment management options that investors can select, which compete with discretionary and advisory unit trust services and discretionary management services such as those provided by stockbrokers and other fund managers.
But of all of the options available, funds of funds are the most efficient from a regulation and compliance point of view. In fact, you could argue that they are the cheapest of the various options available.
This may seem to be a strange comment to make when one of the main criticisms that funds of funds have suffered from in the past has been the double charge effect of a unit trust investing in other unit trusts. But while this was a major problem in the early days of funds of funds, things have changed quite dramatically over the last few years.
First, the introduction of renewal commission has typically reduced the underlying fee from 1.5% to 1%. Then the introduction of the Oeic and the opening of institutional shares, which quite often charge fees of 0.5%-0.75%, has further reduced the burden.
However, the most important aspect of this double charge is that it is seen for exactly what it is. It is effectively the investment management fee that the funds of funds manager is charging and should, therefore, be compared to similar fees charged by discretionary and advisory portfolio managers.
In this context, it is neither high nor onerous. Indeed, SIFA, the Solicitor IFA organisation, recently stated that the capital gains tax efficiency of a fund of funds added approximately 1% per annum to capital values.
With the underlying fees now reduced to nearer 0.75% as an average you could almost argue that you are receiving your funds of funds management absolutely free, as an authorised unit trust a fund of funds does not pay capital gains tax on any internal transactions.
This effectively means that for a client using a fund of funds for their portfolio management service they are deferring any capital gains tax liability until they ultimately sell the investment. As we know, most investors continue with their portfolio management arrangements until they die, at which time any liability dies with them.
This leads us on to the specific advantages that funds of funds provide, the first of which is to allow us to construct portfolios that diversify risk without compromising return potential.
To achieve this, we first look at our process on a top-down basis. By getting macroeconomic information from the major investment houses in the market, we are able to shape our asset allocation view and also ensure that from a style point of view we have exposure to the area of the market most likely to perform over the next period. From an asset allocation point of view, we believe it is important not to take excessive risk.
In the early 90s, when the Asian markets were performing particularly well, many investors had as much as 25% exposure to this area. Asia represented less than 3% of world stock markets and clearly this is excessive risk. We take this into account when shaping our asset allocation and we are only marginally overweight in any of the world markets at any point in time.
By far and away the most important investment strategy decisions we take are connected with investment style. By having a balanced fund of funds portfolio with exposure to growth and value styles, we will reduce the volatility and ensure that when styles change, we have an approach that will weather the storm.
We do take positions that will overweight the growth or value style but part of our constant review process is to ensure that we have not taken an extreme view.
The next area we look at in our funds of funds strategy is bottom up. While the FSA advocates that fund managers' periods of outperformance are entirely random in nature, we advocate that by examining managers/funds characteristics, we can determine likely performance outcomes.
We believe it is important to establish the records of funds and fund managers against their peer group. We look at three-year, one-year and six-month performance numbers in order to establish a core universe for each sector from which we do our more detailed analysis and set up our buy and sell lists.
We also think it is important to be aware of emerging trends that are happening in the market. We therefore look at much shorter-term records over six months and three months in order to establish a potential candidates list for the core universe, which again we analyse.
Once we have established our core list, we then set up face-to-face meetings or one-to-one conference calls to identify how a fund's performance has been achieved, what the key drivers may have been to excess return, whether the fund performs well in a variety of market conditions and the implications of the investment process.
We also insist on twice-yearly updates with fund managers as a minimum requirement for any holdings we may have within our funds.
We use a system that establishes the style characteristics of managers (growth or value) and also ensures that we are not significantly overweight in small companies or mid caps for example. This is designed to ensure that we are reducing the risk for the client, one of the main benefits of the funds of funds structure.
If a fund of funds portfolio was used as the core holding (approximately 60%) of a client's investment portfolio, there is still sufficient scope for the intermediary to overweight the client's portfolio in areas that more accurately reflect that client's profile and requirement.
In this context, I hope more advisers will now take a closer look at the funds of funds proposition.
Charges on funds have fallen, reducing double charging.
Capital gains tax efficiency of funds of funds effectively boosts annual returns by 1%.
Funds of funds managers better equipped than most IFAs to manager style exposure.
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