What is meant by fund of funds (FoF) and how are they made up?
A fund of funds is one whose portfolio is selected from other investment funds, giving investors a double level of diversity in their portfolios.
Just as fund managers for single-manager funds vary their approach to stock selection, managers of these FoF choose the funds for their portfolio in a range of ways, with most using a combination of quantitative and qualitative research.
Researchers will look at the ratings that funds have been awarded by agencies such as S&P and OBSR; they will then delve further into the management and performance of potential portfolio members, and will often meet the managers of the single-manager funds.
Funds of funds either operate with a single asset class, UK Equity for instance, or as a mixed fund, such as a ‘Balanced’ fund which will invest in a range of different asset types.
Mixed asset funds are particularly popular because they offer the investor a well diversified portfolio, selected by an experienced fund manager, all within a single fund. Once investors have decided on their risk profile (sometimes categorised as Aggressive, Balanced or Cautious) all further fund choices are left to the manager in charge of running the FoF. The manager will then monitor and manage the portfolio on behalf of the investor.
What are the tax benefits of using a FoF?
As well as the benefits of diversification and expertises, FoF offer a tax advantage. If an investor holds a portfolio of funds directly they would be left with a potential capital gains tax (CGT) charge every time they moved out of one fund into another. By contrast, when sales are made within the FoF’s portfolio no CGT liability is created. Only when the FoF itself is sold would any relevant CGT charge be incurred.
What are the costs for FoF?
Unfortunately there are some weaknesses in the FoF system. One of the major criticisms levelled at these funds is the cost. Initial charges are comparable to single-manager fund, but ongoing costs can be a lot higher. The typical total expense ratio (TER), which includes all annual costs, is generally 0.5% to 1.5% higher than single-manager funds.
That said, careful research can reveal a number of funds that have made progress in restraining their charges to levels comparable to those of individual funds.
In addition to the cost, investors should watch out for ‘fettered’ funds. A minority of FoF fall into this category, meaning that they are restricted in their scope of investment and can only include funds from the same management group as the overall fund. Through investment in these funds, individuals would not necessarily have access to the ‘best of the best’.
Conversely, the majority of FoF are ‘unfettered’ so that the fund manager can invest in the funds of other management groups.