Toward the end of February 2008, stocks dipped and oil prices closed at an all-time high, over $100. Consumer price indices rose and investors worried about their positions following the downward market trend. In such a bearish market, some financiers view fund of funds as a hot investment tool.
In November 2007, funds of funds under management reached $66.2 billion, up from $64.2 billion at the end of the previous quarter and an increase of 21% from Q4 2006. Balanced funds accounted for the majority of funds under management, representing 68% of assets, followed by 18% in equities, according to the Investment Management Association website. Total net sales in this particular class were $1.607 billion, down from $2 billion in Q3 and $1.798 billion year to date.
Funds of funds invest in a diverse range. “They combine the skills of various asset managers within single or multiple asset classes,” said Michel Chikhani head of Asset Management at BLOM Bank. “There are different types of funds of funds,” added Bechara Bardawil, portfolio manager at the bank. They include multi-asset funds of funds (which invest in different asset classes), funds of hedge funds, funds of fixed income funds, funds of equity funds and alternative investment funds (real estate, private equity, etc.). “Ideally, funds of funds manage their holdings towards specific risk and return objectives.”
There are also multi-manager funds, operating in a similar way to other funds of funds but instead of choosing particular funds, they select individual managers who are each responsible for an investment category, explained Fawzi Sabbagh, senior financial consultant in Capital Markets at FFA Private Bank.
According to him, “the main advantage of funds of funds is double diversification, which allows reduced risk, whereas a mutual fund diversifies only across many different stocks. Funds of funds invest in a diversified portfolio, both geographically and among different asset classes, without having to directly invest into dozens of funds.” They also allow overcoming institutional obstacles such as significant minimum investments and enabling smaller investors to access large funds, which have been off-limits to them historically.
High fees
On the other hand, such privileges come with a high fee. Entry fees and charges are, on average, higher in a fund of funds than for individual funds, as top managers tally up their own expenses for the various costs of funds. Charges consist of extra fees and expense ratios, with some funds of funds charging fees at the parent level while carrying high expense ratios. Another disadvantage for funds of funds is liquidity as possible time limitations on the client’s right to redeem shares are prevalent among these funds. “It is more difficult to liquidate your position in a fund of funds than in a regular long fund because they often impose a ‘lock-up’ period of one year, during which you can only cash your shares against payment of a penalty fee,” said Sabbagh.
Now, is paying the extra charges worthwhile? The best funds of funds offer real advantages in both diversification of risk and performance, while others may charge high prices for little returns. In the case of funds of hedge funds, investors will be pouring their money into a range of different products and strategies such as arbitrage, commodity trading, multi-situational and hedging, which may help in reducing the impact of downward market trends. “The manager’s perception of the market will ultimately affect his strategy,” Sabbagh underscored. He emphasized the positive aspects of such funds, which aim at reducing exposure to volatility and risk and seek to preserve capital, regardless of benchmark performance. For BLOM’s Chikhani, other advantages reside in providing robustness in terms of returns and the possibility of relying on the best breed of managers one can get. Bardawil emphasized, however, that in times of crisis, such as the recent subprime meltdown, which led to the current correction, market correlations tend to shoot up. “This implies that within funds investing in the same asset class, the benefit of diversification will not be as effective as in normal times,” said the portfolio manager.
In the opinion of Chikhani, investment in a fund of funds is not necessarily a guarantee of success. “It is vital however to pull the best fund managers together, ones who can boast successful track records over a significant period of time. While some funds are benchmarked and others are absolute-return driven, the essential building block for funds of funds is the common strategy and objectives that bind them together. The big question is that we rarely know which strategy will outperform others in the current economic situation,” he declared.
What selection process should be followed when investing in a fund of funds? “It is a question of trust. You need to have confidence in the fund of funds manager you choose,” said Sabbagh. The financial consultant highlighted the fact that funds of funds remain unregulated for the most part. Some may even be opaque and avoid disclosing losses incurred by shading in future profits over a certain period. Growth of the sector is also estimated on a net basis, excluding funds that went out of business.
Considerations
“It is primordial to verify the manager’s tenure and his track record over a certain period of time,” explained Bardawil. Researching the backgrounds of funds managers and knowing with whom one is investing is an essential process. In Chikhani’s opinion, due diligence of fund managers is indispensable to the selection process. It is also crucial that investors understand the risk level tied to the fund’s investment strategies and ensure that they are suitable to their personal investing goals, risk tolerance, and time horizons. “For a fund of funds to make sense, it needs to provide the same return for lower risk, or a higher return for the same risk; a challenging task for any manager,” concluded Bardawil. Other indicators investors need to look into consider how a fund’s assets are valued, how they are allocated and leveraged, as well as the quality of people on the management team. As FFA’s Sabbagh summed it up, “Diversification, low volatility, guarantee of absolute return and preservation of capital are key elements in any fund of funds.”
