2011 has been quite a year for investors, and often for the wrong reasons. Japan’s tsunami, the ‘Arab Spring’, America’s debt downgrade and Europe’s sovereign debt woes have all helped to make stockmarkets highly volatile. So far the response of many retail investors has been to pile into funds of funds. But is this a good idea?
As the name suggests, funds of funds are unit trusts that invest in a range of investment funds (typically between 15 and 30) rather than directly in equities or other securities. There are two types: ‘fettered’ funds of funds that can only invest in funds run by their own investment house, and ‘unfettered’, which can invest in any fund.
And boy are they popular just now. In the first half of the year retail investors pumped a record £3.8bn into funds of funds. According to figures from the Investment Management Association, there was a real pick-up in the second quarter of the year when £1 of every £8 invested in funds went to a fund of funds. Why?
The reason for the surge is the perceived safety of these vehicles. They are able to invest across any sector and country, and investors hope this diversification will protect them from the market shocks we’ve seen so far this year. “Recent market volatility has made a lot of private investors realise that it is harder to respond to the market than they thought,” says Mark Dampier from fund platform Hargreaves Lansdown. Financial advisers also favour funds of funds as they earn them healthy fees and are an easy sell in the current uncertain climate when few asset classes (other than gold) stand out.
The theory is compelling, but they rarely deliver the goods.
The best-selling Jupiter Merlin Balanced Portfolio has risen by 2.1% in the last 12 months when a cheaper FTSE 100 tracker would have turned in 3.8%. One reason for this is cost. As we’ve pointed out before, common sense suggests low-cost funds will outperform high-cost funds invested in similar assets. And they do.
But funds of funds buy into a host of different funds so they have an extra layer of costs. That translates as higher fees: on average 0.5%-0.75% per year on top of the usual expense ratio. Fettered funds of funds tend to be slightly cheaper, as they’re buying into other funds in-house, but both are more expensive than traditional unit trusts. “That’s not a problem if the fund is delivering the goods, but… few fund of fund managers have the magic touch,” says Emma Wall in The Daily Telegraph.
Our advice? Stick to cheaper exchange-traded funds and investment trusts.
• This article was originally published in MoneyWeek magazine issue number 553 on 2 September 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.