Fund of funds is ‘riddled with flaws’

Investors are continuously struggling to obtain the best asset mix to achieve investment objectives while not over-engineering or overpaying for a solution.

Active management focuses on the following key components to meet their investment objectives: selecting a diversified and appropriate mix of assets, harvesting manager skill, eliminating both unnecessary risks and excessive costs.

A fund of funds’ lack of control of the underlying assets reduces its cost effectiveness

Fund of fund investing has been alive since the early 1960s and has seesawed in popularity ever since. However, it has never thrived because it is a suboptimal way to achieve these key objectives.

In an ideal world each investor would have a team of highly skilled allocators, access to unlimited resources, and a large and commanding asset base on which to design and construct their own optimal portfolio and achieve these objectives.

For those of us that do not live in this ideal world, and are continuously confronted with time and resource challenges, another solution must be devised.

That better strategy is multi-asset investing, which provides a much more robust approach and offers investors a better base from which to achieve their objectives, allowing the investment framework to evolve, integrate a wider variety of opportunities and manage portfolio risks dynamically.

Multi-manager or multi-asset strategies on the one hand, and fund-of-fund approaches on the other, represent compelling solutions on paper. While often lumped together these two strands are distinct, and have many critical differences which can significantly impact the probability of achieving investment objectives.

This makes the reality very different from the theory. These differences are many and varied, ranging from accessibility factors, such as liquidity, capacity and fees, to differences in the degree of transparency, control, choice and flexibility that come with each approach.

A constrained approach

In today’s world, where diversification is more critical than ever, the fund-of-funds approach finds itself somewhat constrained with respect to the range of tools at its disposal. 

Many desirable strategies will not be available to it, as locally manufactured products dominate fund universes – and global players, without the distribution networks required to create economies of scale, stay at home.  Many US investment houses are inaccessible to UK and European fund buyers, for example, but can be employed in segregated account form in a multi-manager context.

It is also likely that a manager’s skill will not be fully exploited in a fund-of-funds format as the ability to customise a fund to meet a specific need in a total portfolio context is lost. 

Each segregated account in a multi-manager, multi-asset framework is bespoke, thereby fully leveraging a manager’s ability and leaving nothing on the table, while ensuring that inefficient overlaps with other strategies are minimised.

Continuing this theme, overall risk exposures can be managed far more effectively when assets are segregated, as the underlying investments are fully transparent at all times. There are no delays in the receipt of underlying holdings information or hours wasted loading external data to internal systems. 

Exposure to Russia or the Ukraine can be found out at the push of a button. Knowing where all your risks lie makes it possible to eliminate the ones you don’t want and maximise the ones you do.

Finally, a fund of funds’ lack of control of the underlying assets reduces its cost effectiveness. Every penny is vital in a low-return environment, and both manager fee savings and implementation efficiencies that can be gained through efficient trading feed directly through to an investor’s total return in a multi-manager, multi-asset context.

It is clear that fund-of-fund investing is a less-optimal strategy, and though it is alive it is riddled with flaws and will never help you to thrive.

Christophe Caspar is CIO for multi-asset solutions at Russell Investments