With Funds of Funds, A One-Stop Advantage
Sunday, October 1, 2006
NEW YORK -- If a mutual fund can be likened to a general store in the variety it can offer, then a fund of funds would certainly resemble a warehouse retailer, allowing investors to pick up enormous variety all under one roof.
A fund of funds, which is simply a mutual fund that invests in other mutual funds, can leverage the expertise of many types of funds and fund managers, said Tom Roseen, senior research analyst at Lipper Inc.
"Instead of having an investment staff that is a jack-of-all-trades and master of none, you're getting people who are experts," he said, comparing funds of funds with some mutual funds. "We are seeing flows go into these types of funds because people want this one-stop shopping."
The primary advantages of funds of funds are diversification and simplicity, said James D. Peterson, vice president at the Schwab Center for Investment Research. "I think the big point with these types of products is do you want to be involved?" he asked. "Do you have the time or expertise to manage your investment portfolio or do you want someone else to do it for you?"
Peterson contends that is why funds of funds have become so attractive to some investors, particularly in 401(k) plans.
Assets in funds of funds now total about $384 billion, up from $261.9 billion at the end of 2005, according to Morningstar. The number of new funds of funds has grown each year since 2002 as well. Last year, 98 funds of funds were added and so far this year 63 have been added. There are 582 distinct funds of funds.
Funds of funds are often broken down by risk so that, for example, an investor closer to retirement can choose a more conservative fund.
A similar type of fund of funds, called lifecycle funds or target-date funds, allows investors to estimate when they plan to retire and choose a fund accordingly. That fund would then grow more conservative in its investments as the year of retirement nears.
"They really do allow an investor to have maximum diversification with a single fund," said Jonathan Shelon, who co-manages Fidelity's Freedom Funds, which are funds of funds. "It would be very difficult for a single portfolio manager to buy thousands of stocks and do a good job managing them.
"We're always told don't put all your eggs in one basket, but nobody says how many baskets you should have, how many eggs should be in each basket and how you move eggs from to the other over time."
Careful management is necessary for funds of funds to prevent holding overlapping securities. Otherwise, investors' holdings might not be as diversified as they think. For example, if a fund of funds were made up of five funds heavy in a hot stock, then the fund could suffer greatly if that stock were to suffer.
Preventing this scenario is where professional management becomes necessary, Peterson said. "The risk of a big blowup is minor."