Funds of funds win performance-wise

Posted 11 19 2007 11:29PM

One of the longest running controversies in the investment world is over whether funds of funds are superior to managers of managers. The former put together a portfolio of investment funds while the latter hand out mandates to particular managers.

For long-only mandates, institutional investors have tended to opt for managers of managers. Data from the retail market, however, suggest the average fund of funds outperforms the average manager of managers.

According to Lipper, retail unfettered funds of funds, which pick from the whole funds market rather than being confined to in-house funds, returned an average of 10.42 per cent over one year to October 31 2007. The average returns over three and five years were 53.2 per cent and 116.97 per cent respectively.

In contrast, managers of managers returned an average of 6.77 per cent (one year), 38.09 per cent (three years) and 66.97 per cent (five years).

Such average performance, of course, can hide significant differences between investment styles. But Jason Britton, co-fund manager at T Bailey, a Nottingham-based fund of funds specialist, says the average fund of funds in the active managed, balanced managed, cautious managed and global growth sectors outperformed the average manager of managers over one, three and five years to August 31 2007.

He attributes the outperformance partly to the fact that funds of funds can move in and out of underlying investment more easily because they invest in retail funds. In contrast, managers of managers draw up mandates for each asset manager to follow through segregated accounts. Mr Britton says the delay in switching managers can impact relative performance.

However, James Millard, chief investment officer of Skandia Investment Management Limited (SIML), says transition managers help to quicken the process for managers of managers and reduce costs to tens of basis points. If the same or a similar mandate is retained then a significant proportion of stocks in the portfolio will not have to be sold.

"It can take days rather than weeks for a manager of managers to change an underlying manager," says Amit Popat, principal at Mercer.

Johan Cras, managing director of Emea institutional investment services at Russell, counter-attacks by saying there are drags on the performance of funds of funds. He says funds of funds may have to retain 5 per cent in cash. This can pull back performance when markets are rising.

Managers of managers argue they have the advantage of a wider choice of managers. "Managers of managers are not limited to retail funds," says Mr Cras. "We do not suffer a bid/offer spread when buying and selling retail funds."

SIML offers both types of multi-manager products but Mr Millard says managers of managers provide opportunities not open to funds of funds. The Skandia Best Ideas fund has 10 underlying managers who provide their best 10 stock picks. "Such an approach would not be possible with a fund of funds.

"Managers of managers also provide greater visibility of the underlying portfolios. By seeing daily trades and positions, managers of managers can understand exactly where underlying managers are adding value."

Average performance data can also hide differences in investment approach, which can explain underperformance by managers of managers. "Funds of funds usually aim to outperform their peer group and a benchmark," says James Hughes, global head of business development of multi-management at HSBC Investments. "They may not have a cap on their level of risk or the amount of tracking error they take."

It is argued this can lead to more volatile performance by funds of funds. Paul Kim, director of Investment Manager Selection, a London-based multi-manager, says: "Managers of managers tend to take a longer term perspective. Funds of funds come under greater shorter term focus because they generally have retail clients."

The potential for managers of managers to better control the underlying portfolios, tracking error and level of risk taken may appeal to institutional investors. This can give rise to more consistent and better risk adjusted returns by managers of managers, says Mr Popat. "An attraction for pension funds is the fact they are striving for returns to meet their liabilities with as little risk as possible."

Supporters of managers of managers also point to the lower cost compared to funds of funds. Lipper says the average total expense ratio (TER) of unfettered funds of funds is 2.37 per cent. In contrast, managers of managers and fettered funds of funds have an average TER of 1.85 per cent. Mr Popat says some managers of managers have TERs as low as 0.80 per cent.

The distinction between funds of funds and manager of manager products may become blurred in future, as multi-managers increasingly use both approaches in a single product. Skandia runs such hybrid products, offering mandates to managers where funds are not available for investment. For example, it granted a mandate to Alliance Bernstein for Japanese equities as the asset manager does not have a fund in the UK.

Another reason for using funds is to gain quick or short-term exposure to relatively efficient markets, such as through exchange traded funds (ETFs), says Mr Hughes.

"ETFs can also be used to increase exposure to sectors that are underweight in existing segregated accounts."