Fund-of-funds: Can it offer tailored investment solutions?

This article discusses fund-of-funds and shows how the structure adds value through manager selection process. It also discusses how such funds can offer better investment solutions and urges asset management firms to offer more such products in the future. 

According to the Web site of the Association of Mutual Funds of India (AMFI), there were 1,043 funds in the country as on September 30, 2008 with assets under management totalling Rs 4,20,862 crore. With 280 equity funds and 471 debt funds, it is small wonder that investors find it difficult to choose appropriate funds to construct an optimal portfolio. 

That is why fund-of-funds becomes a valuable vehicle for investors. 


Paradox of choices 


Fund-of-funds, prima facie, appears a redundant investment vehicle. Such funds after all take exposure to other equity and bond mutual funds — a process that can be easily replicated by investors themselves. The problem is that investors are not as competent as professional money managers at identifying style cycles and manager skill. 

Suppose a person wants to invest Rs 10 lakh today to pay off a certain liability in five years. How should she construct her portfolio of mutual funds? What if she chooses an infrastructure fund when the sector is at its peak? 

Selecting underperforming funds could prove disastrous because the investment will not be able to pay off the liability structure at the horizon. That is why identifying style cycles are important.

Now, take a discerning investor. Suppose she wants some exposure to large-cap value, mid-cap growth, long-term bond fund and a money market fund. As there are many funds available, the investor has to develop some criteria to choose a fund in each category. 

Often, this means choosing the best performing fund in the last one, three and five years. This is not an optimal selection process because no money manager can consistently beat the market.
Manager Selection 


Assume that the market has only 25 professional money managers. If five of them beat the market, it means some others underperform while the rest form the market average. The next year, these five portfolio managers may generate average returns. Later, they may grossly underperform the market. 

Some of the best-performing portfolio managers in the US before 1997 underperformed the Nasdaq during the dotcom era when they failed to ride the technology cycle. 

Selecting portfolio managers who have performed well in the last three years could, hence, be optimal only if their investment style is in vogue in the future as well. 

And that is difficult to forecast. That is why selecting funds that can consistently generate excess returns over the benchmark index (alpha returns) is not so easy. 

A fund of funds structure helps in this regard. The manager of such a fund is expected to have better manager selection skill than an average investor. She also understands style cycles and can, therefore, engage in tactical asset allocation. 

This involves switching from, say, mid-caps to large-caps and from one sector to another to generate excess returns.

The additional layer of cost (MER of 0.75 per cent) that fund-of-funds charge is a compensation for adding value through the manager selection process. 
Offering investment solutions? 



Currently, there are not many fund-of-funds available in the market. Of the ones that are available, some invest only in their own family of funds. Such exposure may not be optimal. The reason is not far too seek.

The best performing mid-cap style, for instance, may be a fund from a competing asset management firm. Taking mid-cap exposure within the family of funds would then be sub-optimal.

But why not use fund-of-funds structure to offer investment solutions to people? This can be achieved using fund-of-funds as a conduit and single asset-class funds as the building blocks. 

Take children’s education fund that some asset management firms offer. Such a fund invests in both equity and bonds and sometimes engages in tactical asset allocation. 

The manager risk is high, as the portfolio manager takes exposure to both asset classes within one fund. Manager risk is the risk that the portfolio manager may underperform her style benchmark.

An optimal alternative would be to offer such exposure through the fund-of-funds structure. Such a fund could take exposure to large-cap index fund, mid-cap active fund and a gilt fund. This reduces manager risk as all managers will not underperform at the same time.