What to look for when selecting a fund of funds?

This article is part of
Multi-Manager Funds: Under the Bonnet - May 2013

At face value there’s little difference between many fund of funds.

Having grown 43% in the last five years (Lipper March 2013), the investment universe is now home to circa 200 multi-manager funds. This number implies that there’s a huge amount of choice, but when profiling the funds on basic attributes, most appear to offer a similar deal.

Each fund is typically risk graded by external risk consultancy firms, such as Distribution Technology. As risk ratings are based on asset allocation and not just volatility, the funds tend to invest in the same asset classes – with often remarkably similar percentage exposures to each. Pricing is also similar, with an average ongoing charge of 1.93% in the market and little spread either side of that figure.

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Not surprisingly, performance differentiation also becomes much narrower. Amongst the fund of funds risk rated 5 by Distribution Technology over the last three years, there has been less than a 6%* spread in performance against the average, compared to 31.2%* in the wider IMA Mixed 20% - 60% Shares sector.

Digging deeper can paint a more accurate picture

Beyond the generic fund profile there are, however, many differentiating factors that could help you separate the wheat from the chaff, and the core attributes for performance delivery are focused on the investment processes and research capabilities of the fund provider.

Strong asset allocation is key. Actively managed portfolios with short-term allocation shifts can bridge the gap between long-term assumptions and current market conditions, while bottom-up stock selection can help identify opportunities beyond the plain vanilla.

Behind a comprehensive stock selection process there must be a strong research and asset allocation team. How big is the research team? What analysis is used? Does the team have industry recognition and solid experience? Does the fund rely on one star manager? These are all questions that should be asked. For example, consider the continuity of a team based approach against the risk of a single star manager leaving the fund. Risk controls should also be investigated. Investment managers use different, proprietary tools to calculate risk and have varying fund analysis processes. Understanding the systems used and how deeply embedded they are into every aspect of the business can help profile a fund more accurately, rather than simple reliance upon a risk rating.

On the issue of risk, assessing the capital adequacy of the investment provider is also crucial. When investing for a client, a company with a fortress balance sheet offers more guarantee of longevity and more peace of mind.

All of this information should be transparent and easily accessible from the investment providers. In fact, many sell their funds on these credentials.

You have a choice, put it to good use

If you are considering using a fund of funds, there is plenty of choice in the market, but while the packaging might often look the same, the palette from which the fund managers paint can make all the difference. Recent performance is undeniably similar across the board, but whether a fund can deliver its objective over the long term and survive varying market conditions can only be determined accurately by looking at the process and team behind it.