Funds of funds are unlikely to set the world alight but for investors on the first rung of the investment ladder they can offer a low-risk introduction to equities
A number of recent high-profile fund launches has meant that fund of funds management is enjoying something of a revival. At this stage of the economic cycle, it is their diversity ' and the reduced investment risk that this brings ' that is the big attraction.
This appeal has been driven home by the poor returns generated by so many unit trusts of late, particularly by sector-specific fads such as the technology boom.
Martin Clements, lead fund manager of two funds of funds at RSA Investments, says: 'The bursting of the technology bubble and sudden decline of global indices affected a lot of people. That's why the industry has suddenly got behind the funds of funds concept again and we've seen fund of fund teams being bought up and transplanted into established management houses.'
For intermediaries with investment clients who may have suffered through buying fad funds in recent years, funds of funds can represent an exciting sales proposition. Michael Lynch, sales director of investment funds at RSA, says the offer from advisers should go something like the following: what if we could get a professional fund manager to take your savings and invest them across a range of different funds and asset classes? And: what if we could get that manager to move your money in and out of the best-performing markets to make the most of global investment opportunities while protecting your savings from the worst market reversals? Presumably, if we could find an expert manager that was willing to do all that with your £50 a month contribution and only charge 1.25% a year, you would be interested.
There are two approaches to funds of funds. One is to operate a team of analysts that constantly review externally-managed funds, but this can be expensive for the fund manager in question.
Costs can also accumulate if the manager in question has to accommodate the charges of those external funds it chooses to include in its portfolio.
Lynch says: 'Costs are inevitably passed on to the investor so the adviser's first job is to ensure they know what their clients are getting. Another consideration with these funds is to look at the risk profile. By targeting the best-performing equity funds from sector to sector, these funds often overlook the opportunity to invest in bond funds or hold cash. While there is nothing wrong with that, it means these funds are chasing out-and-out performance. Consequently, they can be even more risky than normal equity funds.'
The other approach to fund of funds is to find an investment house that selects funds from its own range of Oeics and unit trusts. Clements says: 'The big advantage these sorts of fund of funds have is that, assuming the underlying fund range is of sufficient quality, a fund of funds manager becomes the ultimate asset allocator.
'In RSA's case, it means I can concentrate on taking a top-down view. Once I've decided where my investors are likely to prosper and why, I can rely on the expertise of sector-specific managers to make the most of stock picking within the region. It's a bit like being a fund manager with a team of analysts, the difference being that the analysts are all senior fund managers in their own right.'
Central to a successful fund of funds process is the opportunity to collaborate with economists and investment strategists as well as fund managers and their analysts.
'Balancing the top-down views of economists and with the bottom-up analysis of fund managers is central to running a successful fund of funds,' says Clements. 'Being able to challenge the assumptions made by our fund managers helps to keep them focused, but it also means I can gauge any changes in sentiment in either the underlying markets or the funds themselves and position my investors to benefit.'
Rather than having to make the best of a sector that could be having a hard time, funds of funds can go underweight or simply move out altogether. Conversely, when a market is looking more attractive, a fund of funds manager can simply reallocate capital, sub-contracting the relevant specialist manager to generate the best returns.
It was only a few years ago that, when discussing low-risk investments, the average adviser would have pointed immediately to with profits investment.
A number of fund managers have now moved away from this product, however. Gerry Slora, an adviser with broker Keith, Bayley Rogers, has been advocating a move away from with profits for several years. In light of the bad publicity that providers such as Equitable Life continue to generate, he is rightly pleased to have made the break with convention.
'The rise of a new generation of more sophisticated private investors means that with profits no longer fits the bill,' he says. 'One of the most important elements for any modern investor is transparency. Trying to explain to clients that they will never know how their investment is performing until it matures just doesn't appeal.'
For investors who are on the first rung of the investment ladder, Slora is a strong advocate of funds of funds. He says: 'The first step is to separate out the life insurance element from the investment element. As a 'qualifying' product with profits are reasonably tax efficient but certainly no more so than investing via an Isa.'
Term cover is very competitively priced nowadays so if insurance is required, it is easy enough to take it out of the equation. The great advantage to this is transparency.
Not only can clients see what they're getting but they appreciate that for smaller levels of investment, they're actually getting something quite special.
Whereas a with profits portfolio will typically invest in a portfolio of, say, 80 to 100 stocks as well as gilts and property, the nature of a fund of funds means that investors are buying a share of a portfolio that might hold 800 stocks or more worldwide, as well as bonds and cash.
Explaining that the fund's manager spends all their time weighing up one market against another and adjusting the portfolio to make the most of this for investors also has a strong appeal for new investors.
It is this continuous asset allocation that makes funds of funds so suitable for investors taking their first step away from bank or building society accounts. Slora says he makes a point of explaining that this sort of approach is the closest that small investors can get to private portfolio management.
As Clements explains: 'The funds do exactly as I would if I were running my personal portfolio but at a fraction of the cost. Recently, for example, I let the funds build up reasonably high cash holdings to shelter them from the worst of a falling market ' not an option for most equity fund managers.
'Now I'm steadily reducing the cash levels to take advantage of relatively cheap equity markets, particularly in the US, and staying poised to jump on the Far East and emerging markets as soon as we see signs of a recovery. I dread to think what that would cost me if I tried to invest like that on my own.'
• Funds of funds have become popular again after tech bubble burst and global slowdown prompted managers to look elsewhere.
• Costs and risk profile are key considerations.
• Ideal for risk-adverse investors taking first step into equities.
Staying invested could prove lucrative
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