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Fund of Funds: Perfect Solution or Dangerous Shortcut?

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

It would be nice to achieve all of your investment objectives with a single fund. At first glance, a mutual fund that invests in various other funds ” called, appropriately enough, a “fund of funds” might seem like an easy way to do that. However, fund of funds are not always what they appear to be.

With this type of investment, you must do more than just pay the expenses associated with running the fund. You are also charged all of the expenses of the underlying funds.

Higher expenses are just one problem with this idea. But before we get into that, let’s spend a minute on the fund’s potential appeal.

Different Types Of Fund Of Funds

In theory, with a fund of funds you get diversification, professional fund selection and monitoring, and built-in asset allocation, all bundled into one convenient mutual fund.

There are a couple basic types of fund of funds.

Some rotate sector funds in and out of the portfolio as the fund manager sees fit. The manager then, at least in theory, avoids sectors in decline while participating fully in sectors on the rise. This assumes, however, that the fund manager can predict which sectors and funds will benefit during each phase.

Again, that’s the theory. To believe that a fund manager can somehow know in advance which sectors will perform well and which will not takes a leap of faith unsupported by any mutual fund performance figures.

Asset allocation or “life cycle” funds are another type of fund of funds. These funds diversify your investment by holding several different asset classes at the same time. For example, life cycle funds hold one or several stock funds along with one or more bond funds. By varying the proportion of stocks to bonds, the fund attempts to provide an appropriate asset allocation for investors in differing stages of their lives.

With that by way of background, before you invest in one of these funds, consider:

1. The asset allocation might not be optimal. The mixture of stocks to bonds might not exactly match your needs. Or you might prefer a different mix of investments than the fund manager has selected. You might, for example, want more (or less) foreign stocks instead of domestic, or you could prefer large to small, or growth to value. And it’s possible you might want bonds of a different duration than offered by the fund.

2. Fund selection can be constrained by business decisions of the sponsor.

  • At a leading discount brokerage house, funds share management fees or pay distribution fees in order to participate in the sponsor’s plan. This arrangement creates a clear conflict of interest, leading directly to fund choices with higher-than-average fees.
  • In other cases, the fund choices might be limited to funds offered only by the sponsoring mutual fund company, potentially limiting asset class availability or giving preference to funds with inferior structure or performance.

3. Even if you are content with all of the asset allocation and fund selection choices, a fund of fund approach makes subsequent re-allocation or distribution planning more difficult. Here are two examples:

  • Suppose you needed to withdraw money to fund your child’s education. With a fund of funds, you’d have to sell shares that hold both stocks and bonds regardless of the tax consequences and regardless of the performance of equities vs. bonds. This could require liquidating equities at the bottom of a market cycle even though you might prefer to hold them until they recover. With individual funds, you could pick and choose depending on your tax situation or investment goals.
  • Or suppose you are approaching retirement and want to increase your percentage of bonds. You’d have to sell many more shares of your life cycle fund to accomplish a normal reallocation than if you held individual funds. As a result, both tax and transaction costs could be substantially higher.

4. One clear advantage of holding multiple funds rather than a single fund of funds is the ability to actively manage taxes. For example, by selling a mutual fund at the end of the year you can generate a tax loss (which you might want to offset some taxable gains) or avoid a distribution. This opportunity isn’t available with a fund of funds.

5. Finally, some funds of funds “manage the managers.” The objective here is to keep the fund invested in top-performing funds. But in the process, the fund might simply chase last year’s heroes, churning their own account and creating horrendous tax problems for the shareholders. For this I need a manager?

Not every fund will have all of the problems listed above. Occasionally a fund of funds might even be a reasonable option for some investors. But it’s certainly not guaranteed. Each investor should independently determine his or her individual asset allocation plan and fund selection process. Although this process might take some time and effort on your part (we can make the process easier), designing and tailoring your investment plan to meet your individual objectives and situation should pay big dividends.