Funds-of-funds costly, but are worth a look

By Bryan Borzykowski | June 14, 2007 | Last updated on June 14, 2007
3 min read

A lot of advisors look to funds-of-funds as an easy, no-hassle way to invest their client’s money. Phenomenal sales are proof of their popularity, but are wrap funds the best way to go? That’s the question Dan Hallett posed at the Morningstar Canada Investment Conference.

At the top of the presentation Hallett, president of Dan Hallett & Associates, mentioned that funds-of-funds can be a quick “turn-key” solution to investing. “There’s strong double digit growth in sales,” he told attendees of Morningstar Canada’s Investment Conference on Wednesday. “This allows you to free up time and helps to service smaller accounts more efficiently.”

Since funds-of-funds invest in many mutual funds, diversification is easy to come by — another benefit, says Hallett. He says a portfolio that includes Canadian and foreign bonds should have 30% Canadian stocks, 15% U.S. stocks, 15% overseas stocks, 35% bonds with one third foreign, and 5% cash.

But it’s the behavioural aspects of this investment strategy that might benefit clients most. Hallett found that investors who leave their portfolios alone — which is common with funds-of-funds — tend do to better than those who constantly mess with their investments. “If you try and make too many changes,” he says. “That’s often a performance detractor.”

He says the funds-of-funds are best used for smaller portfolios — under $50,000 — and should account for most of a client’s investments.

Having said that, Hallett does have reservations with these ready-made portfolios. In fact, he doesn’t really like them at all. “I’m not a big fan,” he says. “For the most part, a good diversified balance fund can do well, if not better than a fund-of-funds. It’s less complex and in many cases, less expensive.”

Costs are Hallett’s biggest beef. He says the MERs are much too high, with the riskiest products charging a premium of up to 60 bps. The most conservative funds-of-funds charge a lower premium, but still cost investors an extra 20 bps. In one unusual situation, Hallett found that Artisan Portfolios charge a 60 bp premium on its most conservative offering, while its most aggressive funds are the lowest priced. “It’s odd because the more conservative the mandate the less likely they are to add any value,” he says, adding this proves advisors must research what’s out there before delving into a wrap fund.

Besides investigating fees, advisors must find out how many funds the portfolio holds. Hallett believes anything over seven should raise a red flag. “Look for a tight list of funds,” he says. “Less is more.”

About half of all funds-of-funds have more than 10 funds in their portfolios, with the range between three funds at TD and 19 at Keystone. When it comes to global funds-of-funds, more than 60% of them are made up of at least 10 funds.

Rebalancing frequency is another factor which should not be overlooked. Most funds-of-funds promote the fact they rebalance quarterly or even semi-annually, but Hallett says that’s too often. They should be rebalanced once a year at the most frequent, but ideally every two years.

Doing this will avoid what he calls performance dilution.

“People are holding too many funds,” Hallett says. “If you think about it, think of the industry, the IFIC categories, as one giant portfolio. In that context it starts to become clear that this bloated list of products would look very much like an index, of course not charging index-like fees.”

While fees and the number of funds are important factors, it’s equally as pressing to find a company that has a clear questionnaire. “You want a robust (document),” says Hallett. “Most of the ones I see don’t ask for a return target. It’s more qualitative stuff.” He says most wrap funds pay attention to the risk side as opposed to return.

Since Hallett sees flaws with most questionnaires — as he does with several other aspects of funds-of-funds — he says it can be tough finding the ideal company to put on your shelf. “But if it exists, you should know what you’re looking for.”

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Bryan Borzykowski