Funds of funds provide easy diversity, but are they worth the cost?

The idea might be good, but the extra layer of management costs money which is not always repaid in better returns. Emma Dunkley reports

Deciding where to invest amid global market uncertainty could leave you procrastinating as much as Shakespeare's Hamlet. So instead of trying to pick where to put your cash to work, you could find a fund of funds manager to choose a variety of funds to spread your risk. The idea is that the manager will have the expertise to choose the best performing ones.

It is no surprise that many people are turning to fund of funds managers after the large swings in markets last year. In the first six months of 2011 alone, investors pumped a record £3.6bn into fund of funds, compared with £3.1bn in the same period the year before, according to the Investment Management Association.

And even if you consider yourself a dab hand at choosing where to place your money, these managers have far greater access to research and the top funds in the market, as well as the investment expertise to package it all together.

"Fund of funds are being recommended far more by many financial advisers who are realising that they don't have the resources to effectively analyse funds and put together investment portfolios," says Patrick Connolly of AWD Chase de Vere. "Fund of funds supposedly provide an all-in-one investment solution, which is lower risk than investing into individual funds."

On top of these benefits, fund of funds arguably make it easier if you want to buy and hold your investment over a longer period of time, as you don't have to continually monitor all the underlying holdings.

But these benefits come at a cost, literally, with higher charges than a typical individual fund. The manager will impose annual charges, but as the fund invests in other funds, which also have charges, you are hit with two sets of fees rather than one.

"Surprisingly, most fund of funds managers impose a similar level of charges to active fund managers who have to research individual shares," Mr Connolly says. "This, coupled with the underlying charges, means that an investor can often be paying total annual charges of around 3 per cent, which is very expensive. Charges at this level are a huge constraint on performance and mean that funds of funds have to perform very well just to stand still in real terms."

But the best-case scenario of superior performance outweighing the high fees is not necessarily a reality. Alan Miller, co-founder of the wealth manager SCM Private, says: "Unfortunately there is strong evidence of fund managers selling a dream which they simply cannot deliver. The traditional approach of these funds of funds, of cherry-picking the best managers in each market, is fundamentally flawed. In fact 2011 proved to be one of the worst years for active managers over many years."

Indeed, some independent financial advisers are steering clear of funds of funds because of these extra costs. Yvonne Goodwin of Yvonne Goodwin Wealth Management says: "I specifically don't use them as it is an extra layer of charges for clients. As I give each client a bespoke service, they don't need the added cost.

"I think some advisers use funds of funds where they have a huge number of clients to service, with relatively small pots of money that don't warrant the time involved in doing bespoke portfolio work for them."

But in such a tough economic environment, it is hard to accept that funds of funds, some of which have a total expense ratio of 2 or 3 per cent a year, will have to return this amount before you start to see your investment grow. Darius McDermott, the managing director of Chelsea Financial Services, says: "Many funds of funds fail to do this and generally underperform the sector average, but there are some that do well for investors and they shouldn't be written off entirely as they may be suitable for certain types of investor."

Some have performed notably well despite the economic turmoil. "The multi-manager team at Jupiter has a consistent record of out-performance and so, to date, they have largely justified the high charges on their funds," Mr Connolly says. "There are also some funds which do a good job of diversifying risk, performing well and having competitive charges. The Cazenove Multi Manager Diversity fund falls into this category."

Nonetheless, top quality funds of funds are in the minority and you might be better off buying individual funds. Mr McDermott says: "For investors who don't want to pay such high charges, a cheaper way of achieving a similar result is to invest in a number of funds yourself and therefore only pay the stock-pickers rather than the asset allocators. But you will need to monitor your investment and realign regularly."

If cost-saving is your main priority, there is a new type of fund of funds which has lower charges. Rather than a manager selecting a range of funds run by other managers, he or she chooses low-cost passive investments, like index tracker or exchange traded funds (ETFs). Not only do they offer lower charges than typical funds of funds, but they can provide diversification across a range of asset types.

If you do not want the burden of choosing where to invest and would rather have an investment professional take the reins, then Mr Miller says funds of low-cost products such as ETFs are a sensible middle ground.

Fidelity, for example, has three such funds, with total expense ratios of just above 1 per cent.

With such low-cost funds of funds emerging, you would be wise to consider these alongside the more expensive versions, as cutting costs will pay dividends in the long run.

Emma Dunkley is a reporter for citywire.co.uk

Expert View

Patrick Connolly, AWD Chase de Vere

"A fund of funds seemingly offers an all-in-one investment solution and gives investors access to the top fund managers. However, these benefits come at the cost of higher charges, meaning that many funds have to perform well just to stand still in real terms. With a handful of notable exceptions most funds charge too much and deliver too little."