The growth and diversity of financial services presents the investor with a dizzying array of choice...
The growth and diversity of financial services presents the investor with a dizzying array of choices to make. As the financial services industry continues to evolve the investor is faced with having to monitor developments, to ensure that the original choice remains the most efficient option.
For those investors who choose to invest directly in stocks and shares the last year has been incredibly turbulent. Firstly there was the amazing outperformance of technology, media and telecommunication (TMT) related companies towards the end of the Millennium, and then the swift correction in the same stocks just months later. Volatility, and therefore risk, continues to be a feature of global markets.
Against this backdrop it is perhaps unsurprising that funds of funds are becoming increasingly popular as a core holding with investors and advisors.
Funds of funds were traditionally unit trusts offered by fund management houses that were made up from only their internal range of unit trusts or Oeics.
While this provides the investor with a well-diversified product, it was unlikely that one specific fund management group had the best fund to offer in each asset class (bonds and equities) let alone in each region.
This has led to the development of the multi-manager approach, where the fund of funds attempts to create a portfolio by selecting the best unit trusts and Oeics from all fund management houses. Some fund of funds have taken this a step further by refusing to hold any internal unit trusts, so that they remain truly independent and thus free from pressure to seed new funds or remain holders in the event of a manager/team defection.
Funds of funds offer the investor an excellent way to diversify risk. Methods of portfolio construction vary, but this point can be illustrated by taking the method used at Friends Ivory and Sime for managing the Friends Provident Independent Portfolio Trusts.
Portfolios are constructed using a range of 25 actively managed unit trusts and Oeics in combination with trackers to help reduce risk. Trackers are utilised in regions where research has indicated that stock markets are efficient, principally the US and UK, and these give low cost exposure to literally hundreds of companies.
The remaining funds are divided in to core and satellite holdings. Core holdings are actively managed funds that are well diversified (in excess of 80 stocks) and expected to provide above average returns at below average volatility.
Satellite holdings will form a smaller weighting than their core counterparts and are typically less well diversified and more aggressively managed, but they are included to harness significantly above average returns whilst taking a controlled level of additional risk.
Such a diversified level of funds, with each containing between 40 and 800 stocks, means stock specific risk is well diversified, and therefore the affect upon the portfolio of an individual stock underperforming would be minimal.
The international dimension of fund of funds aids risk control further. By spreading investments among many different regions the investor reduces market specific risk, for example the extended bear market in Japan that has seen the Nikkei 225 Index lose 60% of its value since the end of 1989.
International diversification also reduces the effect to the portfolio from country specific political risk, such as the continued underperformance of the Indonesian market due to the years of alleged corruption by the former President Suharto.
Currency risk is also reduced as a weak euro, for example, can be offset by the corresponding strength in the dollar or sterling.
Some of these benefits can be achieved by investing in a well diversified international equity fund, however fund of funds are able to diversify risk still further, to a level that international funds are unable to attain.
The other layer of risk control that multi-manager incorporates is the risk relating to the incumbent management of each of the underlying unit trusts.
Many funds are promoted to the public on the basis of past performance generated by either a "star fund manager" or a "star team of managers and analysts."
However when the fund manager or team leaves for pastures new there is little notification given to the existing unit holders, and even if there were sufficient disclosure, the unit holder is not generally in a position to analyse the full impact of the change.
This is not to be understated, as those familiar with the unit trust industry will know. Fund managers tend to move around, and the rise in strength of the performance fee paying hedge funds, has meant there are even larger rewards available to tempt them to do so.
Fund management groups are attempting to retain their staff with higher salaries, bonuses and even creating in-house hedge funds, but still fund managers are moving.
By holding many unit trusts, funds of funds are able to diversify this risk, but, more importantly, there are trained investment professionals running funds of funds who have the time, resource and experience to fully analyse the implications of the change in management.
Therefore, when an unexpected event occurs, such as a change in manager for one of the underlying unit trusts, the company is in a position to collect all the necessary information, analyse it and then act.
The team uses a tried and tested method for fund selection. Initially a quantitative screen is used to determine those funds that exhibit the characteristics we are looking for; such as consistent long-term out performance combined with low volatility.<
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