Pretend, for the moment, that you and I run a mutual fund company. We have the usual collection of stock and bond funds. Some do well and some do poorly, depending on the economic climate, the state of interest rates and the mood of Wall Street.
But one day, as we're sitting around trying to figure out how to attract new investors and bring more money into our family of funds, we get an idea. Wouldn't it be terrific, we ask ourselves, if we could create a fund that would invest in several of our other funds -- especially those that perform the best.
In short, if we could do that, we would have a "fund of funds."
With that kind of fund, we could move our money around as market conditions change, going more heavily into the funds that are rising, while cutting back on our investments in the funds that are falling.
Investing in a variety of funds would give us good diversification and this, in turn, would tend to lower our market risk. But, because lower risk might also lower our potential gains, we might improve our performance by beefing up our investment in rapidly growing companies, whose stocks tend to rise faster than the average.
Enthused about the idea of a fund of funds, we decide to see how such a creature might perform and we call in our number crunchers. They develop a bunch of scenarios and run them through the computers.
When the number crunchers finish blending mathematics with intuition, they suggest that if we'd been running a fund of funds for the past five years, we would have done at least as well as the broad market and maybe better.
So, we write a proposal for a fund of funds, toss in our charts and our computer printouts and trot it all down to the Securities and Exchange Commission.
We tell a SEC official we want approval to create a fund of funds and she says, "You want WHAT?"
She then points to the law that says a fund of funds can't put more than 10 percent of its money into other mutual funds. In other words, we can't create the fund of funds unless we get a special exemption from the SEC. And that, we can tell, is not going to be easy.
The SEC, as it turns out, has more than a few concerns about our idea. The SEC, for instance, is worried about investors being charged two layers of management fees -- first by the fund of funds and second by the underlying fund in which the fund of funds has bought shares.
The SEC also is worried about the fate of the investor in the underlying fund. For instance, what will happen if the fund of funds suddenly decides to pull its money out of an underlying fund? How much damage could that do to the investors? And could a fund of funds manager force his colleagues who manage the underlying funds to follow his investment ideas?
Beyond all these concerns is a law Congress passed in 1970 limiting fund investments in other funds. And the law says that before the SEC can grant an exemption, it has be satisfied that the exemption is "in the public interest."
If those weren't enough hurdles, there also is the memory of the 1960s when a fellow named Bernard Cornfeld built an investment empire on the fund of funds approach, only to have it collapse at enormous cost to investors. Fugitive financier Robert Vesco was part of that story.
Little wonder, then, that it took T. Rowe Price Associates, the Baltimore mutual fund company, about three years to win SEC approval for its new fund of funds, called the Spectrum Funds.
But they did it. And now the T. Rowe Price folks are trying to woo investors. One potential sales pitch will be: "If you are confused about which fund to invest in, because we have created so many funds, the Spectrum Funds will give you a little bit of everything."
The Spectrum group consists of two funds. One is Spectrum Growth Fund, basically a stock fund, and the other is Spectrum Income Fund, in essence a bond fund.
Each fund will invest in a total of seven other funds. The Spectrum stock fund will invest in T. Rowe Price's Growth Stock Fund, New Horizons Fund, New Era Fund, International Stock Fund, Growth and Income Fund, Equity Income Fund and Prime Reserve (Money Market) Fund.
The Spectrum Income Fund will be invest in the New Income Fund, the Prime Reserve Fund, High Yield Fund, Equity Income Fund, International Bond Fund, Government National Mortgage Association (Ginnie Mae) Fund and Short-Term Bond Fund.
"By investing in a mix of funds and combining different investment approaches, each Spectrum Fund is designed to help you achieve your goal in any financial climate," the Spectrum sales literature declares.
To get SEC permission to open the Spectrum Funds, T. Rowe Price officials had to agree to certain conditions. The main condition was that Spectrum would not buy more than 15 percent of the shares of any other T. Rowe Price Fund.
Spectrum also had to agree not to redeem more than 1 percent of an underlying fund's assets during any month.
Finally, T. Rowe Price also had to arrange its management fees to avoid layering, or double charges. The firm did it by not installing any fees for the Spectrum Funds. However, each Spectrum fund will have to pay its pro rata share of the management expenses of the underlying funds.
For Spectrum Growth, that figure is expected to amount to between 0.80 percent and 0.94 percent per year. For Spectrum Income, the charge would be 0.89 percent to 1.04 percent.
On a $1,000 investment, using a mid-point charge, at the end of one year, the investor would pay $9 for the Spectrum Growth Fund and $10 for Spectrum Income.
To lead its grand march into the fund of funds world, T. Rowe Price chose Peter Van Dyke, 51, a Harvard-trained mathematician with an investment background. At T. Rowe Price, Van Dyke has been managing the firm's Ginnie Mae Fund.
For the scholarly Van Dyke, president of Spectrum Funds, the new job will bring a special challenge that will test both his mathematical and investment skills.
For instance, there will be some mind-bending questions about levels of cash.
In Spectrum Growth, each of the underlying funds will at any given time be holding some cash. But if the total cash being held by the group creates a cash level that is uncomfortable for the goals of Spectrum Growth, Van Dyke will have to figure out how to adjust that. That could require shifting Spectrum's investment percentages in some or all of the seven funds.
Generally speaking, Van Dyke said, his task will be to monitor, analyze and balance risk and reward scenarios and the potential return for the different fund investments available.
The Spectrum funds will be watched closely in the mutual fund industry. If the Spectrum Funds produce good results, other mutual fund companies may be tempted to clone the T. Rowe Price structure, put their own name on the package and ask the SEC for permission to open them.
There are, in fact, about a dozen fund-of-funds-type operations in the country. Most are relatively small. The biggest of the group is the Vanguard Star Fund, now about five years old, which has $1 billion.
For the five years ending June 30, the Star Fund had gained 79 percent while the Standard & Poor's 500 was up 122 percent, both with dividends reinvested.
John Bogle, head of Vanguard, said that the Star Fund originally changed its asset allocations periodically, but later switched to putting 62.5 percent of its money in four Vanguard stock funds, 25 percent in two fixed-income funds and 12.5 percent in one money market fund.
Bogle declared himself "ecstatic" over the growth and performance of Star. He said he found that Star Fund did not go up as much as the stocks in the S&P 500 in bull markets, but did not go down as much in bear markets.
But Van Dyke, noting that the Star Fund does not have an international component, said he believes Spectrum's investments in the global arena will help give him a leg up on the competition.
"I'd be disappointed if I didn't beat the Star Fund," Van Dyke said.