Often perceived as too expensive, funds of funds tend to be ignored by the majority of advisers, however, the true value of these products is found in their investment performance after charges
Buoyed by the explosion of open architecture, multi-manager products have seen a surge in popularity in recent years, with global annual growth rates of 18% set to continue. However, despite their recent success, funds of funds have been unable to shirk accusations that they are too costly because they double-charge the end investor with two layers of fees.
In fact, of those advisers who do not sell multi-manager products, nearly half of them steer away based on their perception that they are simply too expensive.
Consequently, a number of questions need to be answered. It is true that multi-manager products generally cost more than their single-manager cousins, but by how much? What is the relative value that each type of fund delivers to investors? Why are some multi-manager products more expensive than others? Which types of funds of funds deliver the best performance? What signifies best performance? And should multi-manager products be measured on absolute returns, risk-adjusted returns or returns relative to a peer group or benchmark?
Clearly, a closer look at these products is needed before any sweeping generalisations can be made about the relative value of multi-manager funds versus single-manager alternatives.
The Fee Debate
Figure 1, below, illustrates the relatively small difference in average total expense ratio (TER) between UK multi-manager and single-manager products - a premium that generally ranges from 0.59% to 0.69% annually, depending on the asset class.
Multi-managers typically charge an annual management fee of 1% or more, but most get rebates from the underlying asset managers in exchange for the broader distribution opportunity that multi-managers can provide.
The end result is a total fee for multi-manager products that is still more expensive than a single-manager product, but not as expensive as one might expect and certainly far short of the two-times level that is sometimes assumed.
It is also important to keep in mind that while both types of products are indeed mutual funds, they do not necessarily behave or perform in the same way. Hence, when exploring the true relative value of these products, the fees themselves are really less important than the actual investment performance after charges.
In other words, after annual fees are paid, which type of fund will generate the highest returns for investors? Interestingly, as Figure 2 shows, multi-manager funds have been able to generate comparable, if not better, performance after fees than similar single-manager funds over the past three years.
The comparison does not stop there; multi-manager funds are also able to absorb some of the hidden costs that often sneak up on investors of single-manager funds - unlike single-manager funds there are no switching fees charged to a multi-manager investor when the underlying funds change. So, over time, the transaction costs of active portfolio management may exceed the running costs of a multi-manager approach.
Moreover, depending on the country, there could be significant tax advantages to a fund of funds structure. Typically, all fund purchases and sales that occur inside a multi-manager product are free of capital gains tax, whereas switches between one single-manager fund to another may be subject to tax in some jurisdictions.
While it is quite a challenge to research and monitor a universe of more than 8,000 funds, some advisers have proved they are quite good at picking funds for their clients. The problem for many advisers, however, is managing discretionary portfolios for 300-400 clients can be extremely time consuming and leaves little time for the activities their clients value most - relationship management and holistic financial planning.
Many distributors are seeking to evolve their business models to improve the consistency and ongoing suitability of the investment advice given to their end customers. They are increasingly looking to use external providers of research, fund selection and portfolio management, and in some cases are designing specific risk profile funds to match typical customer-need models.
Importantly, this freeing up of advisers from the duties of portfolio management allows them to spend more time with customers and, of course, to see more customers. This virtuous circle can be a genuine source of growth in sales and productivity.
Emerging pricing trends are not overly clear at the moment. On the one hand, increased competition within the multi-manager space could put pressure on assemblers to lower fees, which in turn could mean a shift toward institutional manager of manager products where fee structures are more flexible. On the other hand, the emergence of specialist multi-manager products such as sector funds of funds could drive fees higher, particularly if these products are able to deliver strong investment performance.
One trend that could emerge is the strategy of capping or subsidising fees in an effort to be more competitive. This move enables funds to be competitively priced from the outset, with fees in line or below the industry average in just about every multi-manager sector. The reality is that only a handful of firms have the size, scope and private ownership structure to be able to make such a bold, strategic pricing move.
In conclusion, it is clear that multi-manager products offer some unique benefits and can address a whole different set of investor and adviser needs. Those multi-managers with the scale to spread their research and investment costs across a broader asset base will have a distinct advantage as the multi-manager market becomes more competitive.
Moreover, with open architecture extending further into the world of multi-manager distribution, there is even greater demand for such products across markets, channels and customer segments.
The old model of a large distributor selling only its own fund of funds is breaking down, as these firms begin to offer access to third-party multi-manager funds. In this rapidly expanding environment, it is likely the larger players, with global resources, better access to managers and the ability to attract and retain the best talent, should outperform over time.
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