While skittish investors have been quick to pull their money out of stand-alone mutual funds since the current period of market volatility began last August, investors in fund-of-funds products are holding on for the long-term.

In its annual review of the mutual fund industry, The Investment Funds Institute of Canada (IFIC) reported that fund-of-funds purchases outnumbered sales of stand-alone funds by about 12 to one in 2007, on a per fund basis. Average sales per fund in the fund-of-fund category during the year were $5.1 million a month. This compares to average sales per stand-alone long-term fund which were $429,000 monthly.

Net new money into fund-of-funds amounted to $16.2 billion for the year up from $9.6 billion in 2006. Investors also switched an extra $4.2 billion into fund-of-funds.

Funds-of-funds also won out over stand-alone funds in terms of stability. Whereas market volatility sparked redemptions out of long-term stand-alone funds during some months of 2007, fund-of-funds held their ground by posting positive sales.

"Even in the months such as August when the credit crunch began to effect markets worldwide, fund-of-funds sales were positive at $787 million, while stand-alone fund and money market fund net redemptions were $1.4 billion and $916 million respectively," says the IFIC report.

Only in January 2008 did fund-of-funds show net redemptions, which IFIC explained was an anomaly accounted for by certain fund closures.

Often used as a core part of an investor’s portfolio, fund-of-funds, also called fund wraps or portfolio funds, offer investors a packaged investment solution through a mix of funds diversified over asset class, geographic region and management style. Fund-of-funds often provide asset rebalancing and active, tactical management services. Some of these products or programs also take into account risk tolerance or other factors such as years to retirement.

Why are fund-of-funds showing sales stability despite market volatility? Dennis Yanchus, statistics analyst with The Investment Funds Institute of Canada (IFIC) says one factor relates to the diversification that these funds offer, plus investment psychology. "It is hard for people to watch a (stand-alone) fund go down. But with portfolio funds, you are looking at the whole return."

While these diversified products haven’t had the sky high returns that a stand-alone Canadian equity fund may have provided over the past few years, they haven’t had the big dips that such funds have experienced since the sub-prime fiasco came to light last August. "Volatility has been much lower," says Mr. Yanchus.

Rebalancing key

The rebalancing service integrated into these solutions is a key advantage, Mr. Yanchus adds. To rebalance a portfolio, an investor must sell high and buy low. But for an individual investor, "this is hard to do in practice." Not many individual investors will be able to stomach transferring money from a stand-alone fund that has performed well into one that has done badly.

For example, an investor who is on their own and has five stand-alone funds in their portfolio, won’t necessarily look at the 12% overall performance that the group of funds has earned. Instead, he’ll be alarmed by the one fund among the five that lost 30% and sell it off when it would be better to be buying.

The well diversified fund-of-funds product, on the other hand, would provide just the 12% overall return and the investor is likely to be pleased and stay invested. Thus, these products help control the instinct to sell low and buy high, explains Mr. Yanchus. "Investors respond to absolute loss."

Boomer retirement needs

These products are also filling in the void being left by the trend away from defined benefit pension plans, he adds. The increasing number of Canadians without defined pension plans must save more money into their RRSPs. Fund-of-funds products offer professional portfolio management from fund managers who have taken on a role traditionally filled by pension managers, says Mr. Yanchus.

An example of this kind of approach is target date funds aimed at funding retirement needs. These funds are selected according to the number of years to retirement. Assets within these funds are reallocated toward more conservative investments as the client gets closer to the target date. Such funds obviously encourage sales stability by focusing investors on a date years ahead that matches their planned retirement.

Simplicity sells

Many boomers gearing up for their retirement years find the simplicity of these funds attractive, especially for investors who are not interested in following their investments actively. Mr. Yanchus adds. Buy one product, and you get instant diversification, receive one fund performance statement and the manager takes care of rebalancing the portfolio.

Duane Green, vice-president of strategic alliances with Franklin Templeton Investments agrees that these products are providing the pension style management that investors want for their retirement savings.

Franklin Templeton launched its Quotential portfolio funds in 2002 and now has $8.2 billion in assets under management. It is the number one managed solution outside of the banks, says Mr. Green. These products are "one-stop solutions for meeting retirement needs," he says.

The Quotential funds are actively managed by Fiduciary Trust, a Franklin Templeton subsidiary.

Benefits of stability

Since fund-of-funds products have only been around since 2002 and sales have taken off only in the last couple of years or so, this is the first time the industry has been able to observe how investors would behave with these funds during a period of volatility. Mr. Yanchus says that the positive inflows into these funds despite the market conditions is good news for the industry. "It brings mutual fund companies stability in terms of sales. This helps them do their job in terms of portfolio management."

He explains that sales instability "is hard for fund managers." The problem encountered by managers is that when the market turns sour, many nervous investors transfer their money out. But a down market offers opportunities to buy low, so, just when they should be buying, they have less cash to do so. On the other hand, high markets prompt investors to buy funds, so managers find themselves with increased deposits, but fewer opportunities to find value in the market.

The sales consistency of fund of funds, however, "does improve fund managers’ ability to manage their portfolio," says Mr. Yanchus.

Mr. Green of Franklin Templeton agrees that this stability is an advantage. "Managers are able to rebalance using new flows, rather than sell a position."

Segregated funds market

John Rees, director, investment sales at Equitable Life, says fund-of-funds are increasingly popular in the segregated funds market as well. His company offers 24 third-party stand-alone mutual funds in a seg fund wrapper and one portfolio program: Franklin Templeton’s Quotential funds.

Equitable has been offering the Quotential portfolio for three and-a-half years. It began offering them in its universal life product as an investment option and then as a segregated fund. "We’ve had terrific sales results; Quotential is approaching half of our sales," says Mr. Rees.

Equitable sells its funds through the advisor and MGA channel and advisors definitely like the portfolio concept, he says. What explains this popularity among advisors? In a choppy market such the current one, some advisors are "seeing their limits as portfolio builders," Mr. Rees says.

He adds, however, that there are many advisors who are very capable portfolio builders. "For these advisors we have a strong selection of funds that can be used in building an appropriate portfolio, or to fill in a missing part of a client’s portfolio."

Still, Mr. Rees believes that the main role of an advisor is not portfolio building. "The primary role of the advisor is to identify needs and solutions and motivate the client to take action."

Many advisors find they can more easily stay on top of their clients’ investments when they have a brief list of portfolio funds to deal with versus a long list of stand-alone fund that require rebalancing.

Michael Aziz, regional vice-president, sales and investment products at Desjardins Financial Security (DFS), also says that third party portfolio segregated funds are a hit with advisors. They appreciate that they don’t have to do the researching and rebalancing and can leave this to a professional manager, he explains. "I think, in my humble opinion, that advisors who are trying to gather assets and plan for their clients’ retirements, don’t always have the time to be up-to-date on the markets." Portfolio providers have access to managers around the world, all the best models and all the best research, he adds. "Why not let them do their jobs?"

Just over 30% of DFS’ seg sales are going into portfolios, he says, adding that he thinks the trend in favour of these products will gain momentum since these solutions allow advisors to "spend more time with the client and more time prospecting."

Could do better

While he says fund-o-funds are "extremely popular," David O’Leary, manager of fund analysis at Morningstar Canada is not enthusiastic about the trend. When asked whether they are a good choice for an investor who does not want to be actively involved in following their investments, he replied, "My feeling is that people should become more active investors." Such funds are better than dumping money in GICs for years, or sticking with some mutual fund that you’ve had since you were a teenager, but they’re not the best solution, he contends. "You could do a lot worse than fund-of-funds. You could do a lot better if you have a good advisor and do a little bit of homework."

If an advisor or investor does choose to go the fund-of-funds route, Mr. O’Leary has some advice. "Look for over-diversification. If there are more than 10 funds (in the portfolio), I think I would start questioning it. Twenty is too many, 15 is debatable. It would be a question to ask."

Also, he said don’t just look at the quality of each of the individual funds within the portfolio. "One thing to keep in mind is that you can have several great funds that don’t complement each other well."

The funds should be dissimilar to enhance diversification. There is no advantage in having two funds that are almost identical in terms of asset allocation.