Are funds of funds worth the cost?

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Should you pay Michelin-starred prices for greasy-spoon style returns? Of course not - but that's what thousands of investors routinely do by choosing from a menu of mediocre funds of funds.

These investments appeal to investors who are looking for a one-stop-shop approach. Through funds of funds, investors can diversify their portfolio in relation both to asset allocation and to actual fund selection.

Investors expect their manager to apply their skills, not just to pick the best sub-funds, but to switch them around if a market or asset class turns sour.

There are several advantages to this strategy. First of all, if you are a smaller investor, it allows you to buy into a variety of areas with less initial capital than if you were to mirror a similar portfolio with your own choice of funds. And it can also give you access to funds that are normally only open to institutional investors.

There are two main types of these funds of funds. With 'manager of manager' funds, the 'lead' fund manager appoints external managers to invest tranches of money in certain sectors, funds or regions - and can dismiss them if their performance is not up to scratch.

However, the more common style open to private investors is the fund of funds, also known as a multi-manager fund.

The big disadvantage of these funds is cost. A double layer of charges applies, which over the long term can eat into returns by up to a third. Investors pay the management charges on their chosen fund but also pay charges on the underlying funds chosen by their manager, which inevitably act as a drag on performance.

In the relegation zone

The performance record of multi-manager funds has, therefore, been mixed, with poorly performing multi-manager funds accounting for one in three of those highlighted in the Relegation Zone report published in October 2010 by London-based independent financial adviser Chelsea Financial Services.

Chelsea compiles its annual hit-list of funds that it believes deserve to be junked by looking at consistently poor performers. The firm defines these as funds that languish in the third or fourth quartile each year for three consecutive years.

Of the 85 underperforming funds highlighted this time round, 24 were multi-manager funds - several from big-name players including Scottish Widows Investment Partnership's £1.1 billion UK Multi-Manager Equity Income fund.

Despite the disappointing performance of many funds of funds, investors are gobbling them up by the platter-load. Over £53.6 billion is now invested, compared with £35 billion three years ago. About £6.6 billion poured into these investments in the year to October 2010, out of a total of £24 billion for all retail fund purchases, according to the Investment Management Association.

Darius McDermott, managing director of Chelsea Financial Services, believes a key trigger for the recent boom is the Retail Distribution Review, which means that by the end of 2012, independent financial advisers must carry out full research for their clients.

McDermott says: "With so much on their plate, many IFAs who may also be advising on insurance or mortgages are choosing to outsource the investment decisions by picking multi-manager funds."

Another factor in their rise is that many IFAs are now using these funds to delegate responsibility for investment decisions, after clients blamed them for choosing investment disaster areas such as technology in the past.

Justin Modray, who runs the consumer finance website Candid Money, says: "Funds of funds can make sense for smaller portfolios as they provide a level of diversity and active management which may otherwise not be practical.

However, they're expensive and often used as a cop-out by financial advisers, who receive the same commission for doing less work than is involved in building a portfolio of conventional funds."

Modray warns investors to be diligent: "If you do opt for a fund of funds then ensure you're getting a diverse spread of investments, which should help provide more consistent investment returns and go some way towards justifying the steep overall charges."

What to look out for

Investors need to look beyond the quoted annual management charge to find the total annual charges - the total expense ratio (TER) - that will dent their returns. The average TER on a multi-manager fund is 2.14%, according to fund research group Morningstar, compared with 1.5 to 1.8% for single manager funds.

Without charges, and assuming growth of 7% a year, £1,000 invested would grow to £1,403 over five years, £1,967 over 10 years and £2,759 over 15 years, says Modray. Throw in a 2.14% TER, and those returns fall to £1,268 after five years (10% reduction), £1,607 after 10 years (18% less) and £2,038 after 15 years (26% less).

But watch out, some multi-manager funds make even heftier charges of nearer 3%. Gartmore Multi-Manager, for example, has a TER of 2.9%, and Henderson Multi-Manager, 2.73%. With a 2.9% TER, Modray calculates that £1,000 invested would return £1,223 over five years (13% reduction), £1,495 over 10 years (24% less) and £1,827 over 15 years (34% less).

Some advisers believe that a relatively high TER is tolerable as long as the performance is top-class.

Ben Yearsley, investment analyst at Bath-based adviser Hargreaves Lansdown, which offers its own range of multi-manager funds, says: "What you're paying for is the extra expertise, but there's no justification for a 3% TER. Assuming a 7% annual return, you would really only be getting 4% of that."

Jason Witcombe, an IFA at financial planners Evolve, is more sceptical: "Charges are the one thing you do have some control over, even if you don't have any control over performance. We prefer index-tracking funds to keep costs to a minimum.

"Research has shown that the majority of actively managed funds fail to outperform the market, and a lot of that is down to costs. Add the extra layer of costs that you have with a multi-manager and the impact is greater still."

Modray's calculations show that a low-cost index tracker charging 0.25% would nibble away just £95 or 3.4% of total returns on £1,000 over 15 years.

Witcombe adds: "We get a lot of customers coming in who have bought a bestselling multi-manager fund in the past and haven't really thought about the charges. Too often they don't convert the percentages into pounds. Mention 1.5% on a £100,000 portfolio generally and there is little impact, but when I say that's £1,500 a year they are shocked. After 10 years that removes quite a chunk of your growth."

Why so popular?

Witcombe believes big-budget billboard advertising is partly responsible for the rush to buy these funds, plus the message that they can be a solution for those nervous about risk and volatility.

"Multi-managers say they will pick out the best funds in the UK or US, for example, and put them together for investors," he says.

"But you're increasing costs, and the more funds you have, the more you are diluting that actively managed message. A lot are just creating closet trackers. You might as well buy a tracker at a lower price and then a single-manager fund for a bit of spice. In effect, build your own multi-manager fund."

Cockerill says that the high cost of multi-managers can be most painful for the cautious investor. "You have to put the charges in the context of performance. The growth potential for cautious managed funds is less, so higher charges will have more impact."

He warns investors not to be complacent, especially now there are around 200 multi-manager funds available. "They have mushroomed in the last few years, and that's removed one of their original attractions - less need to make decisions. Now that investors can pick from scores of funds, they should be checking what the underlying funds are invested in."

Yearsley adds that certain funds are simply not appropriate: "I don't see the point of European ones or US or Far Eastern ones. You might as well buy a single-manager fund. Global multi-managers certainly make more sense."

Be your own multi-manager

Why not put together your own multi-manager portfolio? Martin Bamford, IFA at Informed Choice in Cranleigh, Surrey, says: "It depends on your attitude to risk, but as a rule of thumb you should invest the same percentage in bonds or gilts as your age. So if you're 40, then 40% should be in this asset class." The rest can be spread across equities and other assets.

The simplest and cheapest route into an asset class is through a relevant low-cost index tracker or exchange-traded fund. Trackers can cost as little as 0.25% a year in management charges but there will be platform fees on top. Make sure you buy funds through a funds supermarket rather than direct from the fund manager to avoid the 5% initial fund charge.

One strategy worth considering, says Cockerill, is the "cheeky approach of replicating the funds held by a multi-manager you like the look of, such as Jupiter. But you need to keep a look out for any changes to the portfolio."

Another option for cheap diversification is investment trusts. These are companies that invest in the shares of other companies. Cockerill says: "They have their own risks, but you're getting global diversification at a lower cost.

"Baillie Gifford's Scottish Mortgage IT has a total expense ratio of 0.56%, while the Monks IT charges are 0.64%. Over five years, Scottish Mortgage has risen 54%, while Jupiter Merlin Growth Portfolio multi-manager is up 39%, although Jupiter's fund is less volatile."

Brian Roe, 70, from Oxfordshire, chose to focus on investment trusts to create his own diversified portfolio. The former Xerox executive prefers to make his own decisions, after paying through the nose when he invested in funds through an IFA.

"I've yet to be convinced that financial advice is worth the cost," he says. He chose investment trusts which are closed-ended because the charges are so much lower than for open-ended funds, especially multi-manager funds.

"I like investment trusts because they are lower-cost and offer a good investment spread," he adds.

"My wife and I have Scottish Mortgage and Witan, and my pension is with F&C. They are global and highly diversified."

Best on the menu

While there are plenty of duds in the multi-manager market, there are some notable winners. Jupiter is the one manager that IFAs believe stands out from the crowd across its range of multi-manager funds - even if its TERs are on the pricey side (2.63% for Jupiter Merlin Managed Growth Portfolio).

The Managed Growth fund's performance has matched or beaten many single-manager funds in the same sector. Over three years to 2 December 2010, £1,000 invested returned £1,219, compared with £1,284 for CF Rutter Equity and General, the best performing single manager fund in the active managed sector.

Tim Cockerill says: "Jupiter Merlin Managed Growth is one you can rely on. The more I know about the fund, the more comfortable I am with it."

Darius McDermott also likes the hybrid Miton Special Situations, which invests in funds and individual equities: "It's not pure multi-manager, but it made money in 2008 when others didn't, by being heavily invested in cash and government bonds. It's a hidden gem."