A few years ago, the "fund of funds" was a pariah of the mutual-fund industry, following widely publicized scandals. Today, the concept is again gaining converts.
In an era when people have thousands of mutual funds to choose from and often little time to devote to the task, a fund of funds sounds appealing: It invests in other mutual funds (not in specific stocks, bonds, or other securities), and adjusts its holdings as market conditions change.
Back in the 1960s, funds of funds were quite the rage among daring investors. But in the late '60s and early 1970s they fell into disgrace, following indiscretions linked to the Investors Overseas Services and financiers Bernie Cornfeld and Robert Vesco. Mr. Cornfeld eventually settled with federal regulators; Mr. Vesco fled the United States.
Now funds of funds are sprouting up again. Morningstar Inc. counts 48 such funds, of which five are also classified by the Chicago research firm in some other fund category, such as "asset allocation."
Many of the new funds of funds have been solid performers. T. Rowe Price's Spectrum Growth Fund has a three-year total return of 17.2 percent a year.
Should you buy into such a fund? Experts see several possible reasons to do so:
Super-diversification. A fund of funds offers the "ultimate possible diversification," one expert says. Instead of having a portfolio of 100 stocks picked by one manager with a single strategy, for example, the investor might have an underlying portfolio of 1,000 securities, including stocks and bonds, and with several management styles represented.
Making do with limited money. Many people have modest discretionary income to buy mutual funds. While some funds cost $1,000 or less to join, many can run in excess of $2,000. A fund of funds enables a person to gain a back-door entry to many funds he or she would not normally be able to afford.
Management expertise. A fund of funds lets an investor gain access to many top investment managers, not just a few.
"There has been an enormous explosion in the number of mutual funds in recent years," says Robert Markman, who heads Markman Capital Management in Edina, Minn. The firm has three funds of funds. "You've got lots of people in the media now telling people what to buy, or what not to buy. There's just a lot of confusion about investing. A fund of funds enables [an investor] to have someone watching over all the other mutual funds," he says. Presumably, the fund of fund manager can make better and faster decisions than a small investor would, boosting returns.
Tax simplicity. If you regularly adjusted your positions in several mutual funds, at the end of the year you would have a maze of capital gains and losses to report on your tax return. With a fund of funds, you'll have just one net number.
NOW the downside, which is substantial: Funds of funds tend to be expensive, often having a double layer of fees. Not only may investors have to pay a prorated charge for the management expenses of the underlying funds held by their fund, but they must also pay for the management expenses of their own fund. Thus, overall annual charges can sometimes run about 2.5 percent of invested assets, says Morningstar analyst Mark Wright. That is far above the 1 percent or so charged by most no-load mutual funds.
The exceptions are low-cost fund groups that offer funds of funds. Vanguard Group, for example, offers six funds of funds that buy other Vanguard funds. All six funds have fees less than 0.4 percent.
Another possible downside: Many of the more aggressive funds engage in heavy turnover, says Pat Regnier, another Morningstar analyst. High turnover rates puts upward pressure on fees; it also adds an element of risk, since the buying and selling may be done at bad times.
Be aware that, by entering a fund of funds, you are forfeiting a degree of control. If you are putting $100 a month into mutual funds, for example, you may want to be free to make your own decision about whether to put it in a stock fund or a bond fund. A fund of funds may not be for you.
Among the best known funds of funds are T. Rowe Price's Spectrum Growth Fund and Spectrum Income Fund, Vanguard's Star portfolio, and Markman's conservative, moderate-growth, and aggressive-growth funds. Price and Vanguard invest only in their own funds, while Markman, like many other funds of funds, invests in those of many companies.
Mr. Regnier says investors should not compare the performance of a fund of funds simply with that of other funds of funds. The reason? "The funds all tend to have different investing objectives," both as to the types of securities held, and as to the style, such as whether the funds invest conservatively, moderately, or aggressively. Regnier says he is most comfortable about funds from well-regarded family groups such as T. Rowe Price and Vanguard.
Currently, a fund of funds cannot buy more than 3 percent of the assets of another fund not in its own fund family - that is, an "outside fund." This rule is designed to prevent the fiasco of the 1960s, when the collapse of the Investors Overseas Services, which was based outside the continental United States, also brought down several US-based funds that it had invested in. Federal legislation this year or next year will likely ease many restrictions on funds of funds. Meanwhile, some mutual-fund companies want the US Securities and Exchange Commission to expand the 3 percent cap to between 5 and 8 percent. But experts say such an expansion is unlikely.
Still, says a spokesman at Lipper Analytical Services in New York, "More funds of funds can be expected."