A fund of funds can deliver diversity with one‑stop shopping
by Tim Paradis
Associated Press

If a mutual fund can be said to be like a general store in the variety it can offer, then a fund of funds would certainly resemble a warehouse retailer, allowing investors to pick up enormous variety, all under one roof.

A fund of funds, which is simply a mutual fund that invests in other mutual funds, can leverage the expertise of many types of funds and fund managers, according to Tom Roseen, senior research analyst at Lipper.

“Instead of having an investment staff that is a jack of all trades and master of none, you’re getting people who are experts,” he said, comparing funds of funds with some mutual funds.

“We are seeing flows go into these types of funds because people want this one‑stop shopping,” he said.

The primary advantages of funds of funds are diversification and simplicity, according to Jim Peterson, vice president at the Schwab Center for Investment Research. “I think the big point with these types of products is: Do you want to be involved? Do you have the time or expertise to manage your investment portfolio, or do you want someone else to do it for you?”

Peterson contends that is why funds of funds have become so attractive to some investors, particularly in 401(k) plans.

The fund of funds market is indeed growing. Assets in funds of funds now total about $384 billion, according to Morningstar, up from $261.9 billion at the end of 2005. The number of new funds of funds has grown each year since 2002 as well. Last year, there were 98 funds of funds added, and so far this year there have been 63 added. Over all, there are 582 distinct funds of funds, according to Morningstar.

Funds of funds are often broken down by level of risk so that, for example, an older investor closer to retirement can choose a more conservative fund.

A similar type of fund of funds called lifecycle funds or target‑date funds allow investors to estimate when they plan to retire and choose a fund accordingly. That fund would then grow more conservative in its investments as the year of retirement nears.

“They really do allow aninvestor to have maximum diversification with a single fund,” said Jonathan Shelon, who co‑manages Fidelity’s Freedom Funds, which are funds of funds. “It would be very difficult for a single portfolio manager to buy thousands of stocks and do a good job managing them.

“We’re always told don’t put all your eggs in one basket, but nobody says how many baskets you should have, how many eggs should be in each basket, and how you move eggs from one to the other over time.”

Careful management is necessary for funds of funds to prevent holding overlapping securities. Otherwise, investors’ holdings might not be as diversified as they might think. If a fund of funds were made up of five funds, for example, and most of those were heavy in a hot stock then the fund could suffer greatly if that stock were to suffer.

Preventing this type of scenario is where professional management becomes necessary, Peterson said. “The risk of a big blowup is minor.”

However, the expertise and even the diversification of the fund itself can come at a price.

One of the chief criticisms of funds of funds is that their fees can be higher than those of other mutual funds because each constituent fund charges fees, which can add up quickly. On top of those fees, analysts can charge fees to manage the fund.

The bottom line will become easier to discern next year when new regulations take affect that require the overall fee be clearly listed.

In the meantime, many funds of funds from big players such as Fidelity are composed of proprietary mutual funds so those funds of funds have greater control over fees.

Many of the newer funds of funds waive fees or work to hold down fees to make them more competitive in terms of price with other types of funds.

It can be a struggle for some smaller players to hold down fees, though they will often argue their watchful eye justifies the higher fees.

His fee structure is what keeps Curt Teberg, manager of an eponymous fund of funds, from sitting still for too long. Teberg, who administers his fund from Duluth, Minn., is focusing on adding assets in order to drive down fees, which he acknowledges are high. They stand at 223 basis points compared with what he estimates is an average of 170 basis points for the conservative category in which the Teberg Fund exists.

“They certainly have put together a pie that costs less money,” he said, referring to the larger funds of funds.

Teberg contends, however, that many of his clients don’t mind the higher fees because of how closely he manages it. He notes that he’s not wedded to one fund family when searching for, say, a small‑cap growth fund. Management isn’t just about picking funds, Teberg said. His fund, which has $34 million in assets and caters to conservative investors, recently moved much of its money into cash. Teberg has grown uneasy about the direction of the stock market. The fund is up 4.35 percent so far this year.