Although fund of funds investment options are now proliferating, they have been an important part of the retail funds management landscape for some time. MLC, in conjunction with Frank Russell, pioneered the concept in this country with others following and their uptake has been considerable.
The provider of a fund of funds accepts responsibility for prospectus, administration, unit-registry and client service requirements. Characteristically, the provider will also have a meaningful brand and distribution capacity.
Unlike other product manufacturers, however, the fund of funds manufacturer will outsource investment management and may engage the services of an asset consultant to manage this activity. Commonly, the objective will be to identify ‘best of breed’ fund managers and to combine them in such a way as to satisfy the stated investment objectives.
The asset consultant will be responsible for ‘hiring and firing’ fund managers, blending investment styles, deciding asset class exposure and relative weightings and negotiating management expense ratios.
They will also be involved with reporting on underlying fund manager performance, ensuring compliance with investment guidelines and achieving investment objectives.
Large manufacturers may be attracted to this approach given that it allows them to exploit their core competencies such as brand management, distribution, operations, and client service.
There is now a growing case that the culture required for large-scale manufacturing may not be compatible with that required for successful investment management. Consistent with this has been the proliferation of specialist investment houses focusing purely on delivering investment performance and nothing else, such as Perennial Investment Partners, Investors Mutual and Platinum.
Financial advisers may be attracted to the fund of funds approach for the same reason, it allows them to exploit their core competencies.
The life of the typical dealer principal is increasingly complex. Their responsibilities include the provision of professional advice, compliance, due diligence, administration, business management and marketing. Is it surprising that some are now conceding that the active selection, monitoring and re-weighting of asset classes and fund managers should be outsourced?
Financial advisers and their clients have been served particularly well by a handful of large brand managers during the past decade or more, but the decline of the bull market and the fading capacity of these same managers to deliver excess returns is putting the traditional selection process under pressure.
Some advisers will react to this sea-change by seeking out smaller, specialist investment houses with the capability to not only outperform the market, but also to meet retail service expectations.
Yet others will prefer to outsource all activity related to the delivery of investment returns and fund of funds are an obvious solution.
The investor, though, is all important. So do fund of funds serve the interests of retail investors?
By adopting such an approach, one outcome is that the investor will migrate from one fund option to another only when and if there is a shift in risk profile.
The alternative approach means that the investor has assets in several different funds at all points in time.
Even if the investor’s risk profile remains the same, re-balancing will be required and, on occasions, this will trigger unwanted tax events.
All fund manager products will be explicit to the investor and this in itself may prompt re-allocation because of confusion about the relative performance differentials between product options and asset classes.
The worst case scenario is that in the course of any re-allocation the investor also incurs entry, switching, spread or other product-related fees.
The benefits associated with remaining in a well-managed fund of funds consistent with the investor risk profile are obvious. What are the disadvantages?
A fund of funds will not suit all investors. Many of us wish to know exactly who is managing our money and how. The flip-side of fund of funds simplicity is that the investment objective, process and performance of the underlying fund manager is far from explicit and this may lead to investor frustration.
History shows that delivering competitive investment returns via fund of funds structures is not easy and there is a risk that excess returns can be ‘diversified away’.
The role of the investment consultant is critical and requires an objective and diligent approach. Certainly, the consultant will have to be well resourced. Searching the globe for best of breed managers is an onerous and expensive exercise and very few are equipped to do so in any meaningful way.
On the basis that today’s ostriches are tomorrow’s feather dusters, the best of breed will have to be actively monitored and skill is required to verify high quality, true to label investment processes.
One approach may be to utilise a fund of funds at the core of the portfolio and to surround it with high-performance, specialist managers. This core-satellite approach allows for acceptable risk-return outcomes within a simplified portfolio arrangement. As always, the challenge for financial advisers will be to correctly match strategy with individual investor requirements.
Mark Knight is the head of retail investments at IOOF.
