Are funds of funds an investment cure-all?

The first rule of investing is diversify.

The broader the geographic and asset spread of your investments, the more protected you are from the effects of volatility in any one market.

At present, as the stockmarkets rise and fall almost daily, investors are more in need of diversification than ever. With this in mind, many people are turning to funds of funds for simple diversification.

Instead of buying individual assets, funds of funds managers buy a range of investment funds run by other managers. This means that, within one fund, you get exposure to the skills and expertise of more than one fund manager, as well as a potentially wider range of asset classes, sectors and geographic regions.

In the present atmosphere of uncertainty and stockmarket volatility, funds of funds have proved particularly attractive - the amount invested in them has soared from a modest £11 billion back in 2001 to more than £60 billion by the end of last year.

This means they make up more than 10% of total funds under management in the UK - the highest level they have ever reached, according to Richard Saunders, chief executive of the Investment Management Association.

"Investors added £5.2 billion of funds of funds to their portfolios in 2011," he says. "In gross sales terms that means £1 in every £9 invested in funds was invested in funds of funds in 2011."

If the past few years have taught us anything it's that diversification makes sense because it can lower the overall risk of your portfolio and enhance returns, points out Jane Davies, co-manager of the HSBC World Selection range of funds.

"You ought to have several layers of diversification - geography, asset class, fund manager and strategy - and that's what funds of funds can provide," she says. "Being diversified means assets are not correlated with one another, which lowers the risk being taken."

The price of diversity

However, that diversity can come at a price. In most cases, a fund of funds will cost substantially more than a standard fund because, as well as paying the fees relating to the fund, you also have to cover the costs relating to the funds within the portfolio.

It means a fund of funds may have a total expense ratio (TER - a representative figure measuring the majority of charges associated with the fund) that's 25% higher than a standard fund.

This can cause serious problems, according to Darius McDermott, managing director of Chelsea Financial Services. He points out that investors will want to ensure they are getting something for their money in such cases.

"Good asset allocation, good fund selection and a diversified portfolio might be worthwhile, but I'd question if it was worth paying higher charges if the fund of funds only invested in equities and bonds," he says.

"If it offered a basket of assets - such as property, commodities and infrastructure - that would be harder for individuals to replicate and might be worth considering."

The other thing to consider before investing in a fund of funds is how much risk you are prepared to take. While you will benefit from increased diversification, managers of funds of funds still have to decide where to invest and could still make a bad call. A focus on an underperforming sector can be just as detrimental for a fund of funds as for a standard fund.

The good news is that it's generally easier for managers of these funds to shift between different assets as all it really entails is buying or selling a few funds, says Justin Modray, founder of the Candid Money website. However, he adds: "It's also easier for them to place big bets on certain assets, sectors and funds."

"While this can give scope for outperformance, it increases the scope for investment decisions to go wrong." So while a fund of funds should, in theory, be lower risk than a standard fund due to the diversification, the reality is that it still comes down to the skills of the manager.

If a manager makes the wrong calls the fund can still lose money.

What about performance?

The fact that a fund of funds is invested in a broader spread of assets means the potential returns enjoyed during boom times will be diluted. That is why the best performing single-manager funds will usually deliver returns far in excess of the best fund of funds.

For example, over the past 10 years the CF Miton Special Situations Portfolio has been the stand-out performer in the funds of funds universe with a return of 150.91%, according to Morningstar data to 8 February 2012.

However, the best single-manager fund was JPM Natural Resources, which returned a whopping 585% because it could cash in on the resources boom without its performance being watered down by exposure to other asset classes.

The wide array of investments within a fund of funds can also make it difficult to assess how well it suits your investment needs, warns Mark Dampier, head of research at Hargreaves Lansdown. Potential investors, he points out, need to see exactly what types of funds their manager is investing in - and what asset class exposure they are providing.

For example, do you want a high proportion of the fund invested in equities in the hope that stockmarkets will rise sharply, or would you be happier investing with a manager who has a more cautious outlook and is putting your money into relatively safe corporate bonds?

"It's very difficult because no one portfolio will be exactly the same as anyone else's, so investors need to look closely at how they are constructed," Dampier explains.

Great for getting started

Funds of funds offer a one-stop shop for diversification, and although this can come at a price, sometimes the performance justifies the expense.

Funds of funds can therefore have a place within an investment portfolio.

"The advantage of a fund of funds is that it's probably good for those who are a bit less experienced or who don't have the time to make decisions about funds and managers," says Tom Stevenson, investment director at Fidelity Worldwide Investment.

A decent fund of funds will decide the asset allocation mix and pick the funds on your behalf - two tasks that are more complicated than people would believe, he points out. However, they will not provide specific focus on particular sectors, geographies or themes. "The answer is to have both funds of funds and standard funds in your portfolio," he suggests.

"You could have a fund of funds as the core fund and then take a satellite approach of having some more specific, single-manager funds around the outside."


YES: Diversification equals success

"I have been a big user of funds of funds to maximise diversification and believe they have served my clients well," says Geoff Penrice, an IFA at Honister Partners.

"Fund of funds managers use their skills to select the best funds available in the different sectors. These funds have greater diversification, as you will have a variety of fund managers and asset classes, but they do come with an extra layer of charges. The aim is to pick a fund of funds manager who can give enhanced returns that can more than compensate for the extra charges."

NO: There are far better alternatives

"I believe that the majority of funds of funds do not add any more real value than a multi-asset manager making direct investments at a far lower cost," says Neil Mumford, an IFA at Milestone Wealth.

"Many of these funds are mirrors of each other, with the same underlying funds. From my experience, only a very few funds have added any real value over other alternatives. Yet many are around 25% more expensive than standard funds."