Fund of funds and fund wrap products have just come through their first bear market test and sales remain solid so far – so solid that one expert is calling them the industry’s engine of growth.
Often marketed to advisors as a one-stop solution for clients, the products have clearly been a hit with some. According to numbers from the Investment Funds Institute of Canada (IFIC), fund of fund sales totaled $8.78-billion in 2009. By 2010, that number had nearly doubled to $17.9-billion. During the financial crisis in 2008, stand-alone funds went into redemptions to the tune of $6-billion while fund of funds only lost $1-billion.
"There’s a lot more stability in these instruments and that’s reflective in the sales," says Jon Cockerline, IFIC’s director of policy and research. "They don’t go down as much as the stand-alone funds. They don’t bounce back as much either but they’re pretty stable in terms of their sales."
The smoother volatility in terms of performance too is one reason that a lot of advisors and clients have gravitated towards the product. Others, though, are clearly not as impressed with the concept.
This structure, which bundles several mutual funds into one pre-packaged portfolio (investors in turn purchase units of this portfolio), is sometimes used as a simple way to get new investors started; although for their lower-volatility properties, they are probably more useful in a wealth preservation strategy.
Advisors like Paul Haslam of Haslam Financial in Kitchener, Ontario prefer to pick and choose individual funds where the manager is known. "When I look at many of these, they seem to have eight, ten or 12 funds within the fund," he says. "There might be one or two that aren’t all that attractive. They wouldn’t jump off the page at you if you were looking at a list of funds to buy on behalf of your client."
He also points to diversification and dilution issues: "Imagine, $50 a month going into a fund of funds with 600 stocks. I’d rather put that into a good, well run balanced fund."
Philip Lee is a senior fund analyst at Morningstar Canada. He says conceptually, if the product is constructed properly, a fund of funds can be a good investment. That said, he also points out that funds within the fund can change, as can managers on each individual fund. As a consequence, clients could find themselves holding something other than what they originally paid for.
Hiding the dogs
Sometimes it can also look like companies are hiding a few dogs or underperformers in the mix. This might happen, but he says it is more likely that a fund may be included in a portfolio for reasons beyond absolute performance. "Let’s say there was a fund of funds constructed and it included large caps. One particular large cap fund could be performing horribly. It very well could be that large caps are or were completely out of favour – the market was looking for growth and anything that was small or mid cap related was the outperformer," he says. "When they’re constructing these portfolios, they look out a lot further; there’s a much longer time horizon so it does make sense to have this fund that might look like a dog in the portfolio."
As for the diversification matter, he says that if a fund does manage to invest in holdings that don’t overlap from one manager or mandate to the next, the end result could be that the client is investing in a basket of several hundred securities. In this case of nearly "owning the index," he says "you’re really over-diversified and you’re not getting the best ideas. It’s a fine line." There is also the chance that the clients may, in fact, not be as diversified as they think – a value-based investment firm will ultimately create a value-tilted portfolio if they don’t have an external manager overseeing the portfolio.
One other aspect of the product that rubs some people the wrong way also happens to be a factor that proponents of the product like: That advisors can make use of fund wraps to free themselves from the burden of tracking and rebalancing a client’s portfolio so they can instead focus on building relationships or making additional sales.
Even though the funds are marketed in such a way that advisors can outsource the responsibility of rebalancing a client’s assets (one criticism is that this can encourage a "set it and forget it" approach), Mr. Lee says advisors and their clients should be cautious about relying on fund wrap programs as a be-all and end-all investment solution. Funds change, their underlying assets change and managers change.
It’s also possible that underlying funds may not be as attractively priced compared to their peers in the stand-alone fund universe. All of these factors play into a client’s reason for owning certain products in the first place. "The general idea is that these are meant to be one-stop solutions. They try not to change them too frequently," he says. "The management issue is a concern though. You can’t just buy this thing and hold it forever thinking it’s going to stay the same because it likely won’t."
For those happy to keep track of the underlying mechanics, there are a lot of good reasons for selling the product. Oftentimes, fund companies make a point of ensuring that the product is "compliance ready," providing client investment policy statements and other consolidated reporting that typically isn’t supplied or which an advisor’s office would need to create for clients who were buying a portfolio of stand-alone funds. This reporting usually ties in with business or practice management tools and other advisor products for managing the client relationship that go all the way back to the initial client intake questionnaire.
"This segment has evolved from a physical focus on a product, which would be just a stand-alone fund, to focus on a solution or an approach that surrounds the client and the advisor with an overall solution," says Iassen, Tonkovski, associate consultant at research firm, Investor Economics. "The product is designed with both financial advisors and clients in mind."
For clients, one of the best things to like about the product is that owning several different mandates within one portfolio smoothes out returns. "It has the ability to mitigate some of this wild fluctuation," says Rod Tyler of Tyler & Associates in Regina, SK. Mr. Tyler says he uses the products, usually when looking for a lower risk mechanism on behalf of clients who are looking for income products which also provide a little bit of growth. He also says fund of fund products work reasonably well, compared to the alternative, when clients would otherwise retreat to GICs.
"They should only be used after doing a really good risk analysis," he says. These products, he adds, should not be used as a substitute for good understanding. Slotting a client into one of these products based on the responses to a few basic questions doesn’t cut it. "What does that do? It doesn’t help anybody. I think the potential is there for giving someone a simple solution that doesn’t necessarily address the real issue – which is communication. People need to understand what risk really is. They don’t"
Having lower volatility – the funds don’t outperform but they don’t lose money as easily either – along with the growing variety of fund wrap products becoming available makes the product an easy sell with a lot of clients today. Target date funds are now on the market, along with wrap programs that allow some customization as clients actually own the underlying units, not just one unit in a larger portfolio. Some programs also let clients choose when or how often to rebalance a portfolio (a feature which carries its own risks). Having independent managers oversee those managers included in the fund is common. Managers being allowed to make tactical decisions is another relatively recent trend in the segment.
"I think they’re a fine instrument," says Mr. Cockerline. "It depends on the individual’s needs. The market’s rich enough that it can provide the right product for individuals."
No matter what the marketing suggests though, the product, like any other, is still not for everyone. "There’s never one solution that fits everyone and no one is going to design a product that’ll do it for all of them," says Mr. Tyler. He points out that a young client who is regularly adding money and who won’t be taking delivery of their money in the near future can take advantage of market fluctuations that happen over time.
He warns, however, that advisors must ensure that their clients know that investing is a constant process. "If your personality is such that you worry about it all the time…you probably should be buying something that doesn’t have the huge swings," he says. "I think you need to be very careful, when you’re recommending any investment selection, that it meets the purpose you had in mind."