Stocks Section

Double Fee Trouble With 'Fund of Funds'

September 2005

'Fund of Funds' are all the rage and are being heavily promoted by the money management world, not unsurprisingly because they're great for business, reason - They charge double fees!

What Are Fund Of Funds

Traditionally a private investor in the stockmarket would choose to allocate his money into investment funds or unit trusts, perhaps £2,500 into ABC High Income and £2,500 into XYZ European Big Stocks fund. But now the investor would just invest £5,000 into a fund of funds (FoF) and in turn the manager of the FoF would cherry pick a selection of funds to invest the capital.

In effect the investor is relying on an 'expert' to allocate different amounts of money to different fund managers.

The manager of the F0F does not actually manage the money himself, ie choose which stocks/bonds are to be bought
However the FoF manager will decide what allocations to use, ie 50% UK stocks, 20% foreign equities and 30% fixed-income
He will then use this allocation to invest in funds, ones which he feels are run by the best managers

Double Fees

With Fund of Funds there's always 2 different fees to be paid -

The fees paid to all the individual funds, and
The fees paid to the manager of the FoF, this payment is for his 'expertise' in picking the right funds or mix of funds

This double fee structure is what makes Fund of Funds so appealing to the money management business and in turn is what investors should be generally wary about.

Research has shown that the average Total Expense Ratio (TER) or annual charges + other fees for traditional funds is around 1.6%
But Fund of Funds charge 2% - 2.5%

Important: When it comes to fees paid on any financial investment or product make sure you get the whole picture because the industry is very adept at (legally) hiding what they can. For example Fund of Funds are obliged to reveal what they charge but not necessarily on what fees the funds that they invest in charge.

In addition many investors are likely to want some sort of guidance on which Fund of Fund manager they should choose and this will add yet further to any fees charged. It's therefore easy to get in the ludicrous situation where 3 different types of fees are charged. You can now see why Fund of Funds are great business for financial advisors and money managers.

Give Fund of Funds Some Credit Though

Apart from the suspect fee policy many FoFs do perform better than just plain vanilla investment fund. So higher fees are not all bad news, after all any investor would be happy to pay 10%-30% in fees to a manager making 100%+ a year.

Research by Standard & Poors shows that most FoF deliver higher than average performance
In the Active Managed Sector over 3 years (till July 2005) there are 57 funds in total, 26 of which are FoF
After all charges 19/26 FoF outperformed the sector average
In the Global Growth sector there are 120 funds, 14 of which are FoF
Over 3 years 11/14 outperformed the sector

What Are 'Unfettered Funds'

These are Fund of Funds that can invest in their competitor products. For example if you invest £10,000 with ABC fund manager they'll put all that money to work within their own funds. But if you invest in ABCs Fund of Funds they can buy into funds offered by the competition. This is an important point because they now have the leeway to put money into the best funds on the market.

Unfettered Fund of Funds therefore are the products that should be concentrated on.

Tax Advantages of Fund of Funds

Because of the structure of FoFs they can often be effectively used to manage capital gains tax obligations

This is because the Fund of Fund is treated as the investment, not the individual funds that are invested in
For example if you just invested in ABC fund and sold it at a profit, it would be liable to CGT
But if ABC fund was one of the constituent funds within a FoF the profit is not always viewed as a capital gain
As ever with tax matters make sure you fully investigate nuances such as these

Summary

Don't discount Fund of Funds but certainly be wary of the fee structure. Of course make sure you do as much research as possible not just in the Fund of Funds but also who the manager is and what separate funds he or she invests in.

Finally realise that FoFs main aim is to smooth out investment returns AND risk over a time period, and not to try and get the maximum returns possible. Fund of Funds achieve this goal by diversifying between a number of different investment styles, strategies and market sectors.