The hidden detail

MAYA FISHER-FRENCH - Mar 05 2010 12:09

As part of M&G Money's focus on product costs, Maya Fisher-French takes a closer look at the costs of some fund of funds investments

With high annual costs and often below average returns, are fund of funds delivering on their promises?

Many commentators argue that broker fund of funds, in particular, are offering little value and creating layers of costs for clients. Broker funds are created by financial advisory houses, which then invest in a range of underlying unit trust funds. The selling point of fund of funds is that the manager is blending together the various portfolios of the underlying unit trusts to lower risk and improve performance.

Fallacy of diversification
However, Rudolf Schmidt, MD of SEI Investments, a global multi-manager house, argues that the idea of diversification is a fallacy. Firstly, he argues that for many of the broker-managed funds, the in-house skills are weak and not enough work is done to ensure that there is not an overlap in terms of the shares held in the portfolio. "In many cases the product is just an add-on to a financial advisory firm's distribution business; it is not their core business".

Schmidt also argues that given the size of the South African market, there are only about 80 to 150 shares on the JSE that are liquid enough for a fund manager to invest in and, furthermore, most fund of funds invest in the same 10 largest fund managers due to liquidity constraints. As a result it is difficult to achieve true diversification.

Inefficient cost structure
Firstly, you have the costs of the underlying unit trust funds; then there is the cost of "white labelling" the fund -- this is when a management company such as Metropolitan hosts these funds on its platform; then there are the costs charged by the financial advisory house for the asset management of the funds; and finally there are fees paid to the financial advisor.

Smaller broker-run funds often do not have the volumes to negotiate deeper discounts with the underlying unit trust companies, and those that can negotiate rebates with the unit trust companies do not necessarily pass this on to the client. As a result, some fund of funds have total expense ratios (TER) of up to 3,5% a year (see table below). TERs are the total annual costs of the fund and exclude the initial fees charged by the broker. Considering that for many single unit trusts the TER is in the region of 1,5%, this fund would have to outperform the funds it is actually invested in to justify the costs.

In-house funds vs broker funds
Peter Blom of the Association of Savings and Investments South Africa (ASISA) agrees that there are funds with high TERs as the fund manager is not able to negotiate and pass through better fees. However, one must differentiate between the various fund of funds models. The one model that can be both cost-effective and meet investors' need for asset allocation is in-house fund of funds, where the fund manager focuses on asset allocation by blending the various unit trusts to lower the risk profile of the fund. Because they use their own internal funds, they only charge one level of costs. Examples of these types of funds would include Stanlib and Oasis's range of fund of funds.

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However, for broker funds such as Absa's fund of funds, which invest in unit trusts outside their stables, the underlying costs are significantly higher, which is why ASISA has forced them to include all level of costs in the TERs. For example, investors in Absa's Prudential fund of funds pay annual costs of 3,36% -- this for a fund that aims to deliver only 4% above cash.

Benefits of fund of funds
If they are so expensive, why have broker fund of funds become so popular?

Best advice: Blom says the Financial Advisory and Intermediary Services Act (FAIS) has driven some of this behaviour as brokers try to mitigate the risks of selecting the "wrong" fund manager for their clients. By diversifying across various fund managers, the broker is removing some of the risk of poor investment advice.

However, the Financial Services Board is not convinced, and in fact it argues that in many cases there is a conflict of interest with the financial adviser selling their own product. "We are concerned about the conflict of interest when brokers are selling funds that are controlled by them, this needs to be properly disclosed," says Patrick Ward, head of department for Collective Investment Schemes, who adds that the costs of these white label funds also needs to be investigated.

Asset allocation: Fund of funds are able to adjust the asset allocation between equity, cash, bonds and property unit trust funds based on their view of the market. This can be an advantage if the fund manager is able to reduce capital loss as a result of tactical asset allocation. The fund manager can also blend the "best" funds in each asset category to provide optimal performance. Just because asset manager A is good at equities does not mean they are good at fixed interest, for example.

However, before investing one would have to review the skill of the fund manager at selecting the right fund. There are many studies that show that fund managers are prone to chasing last year's returns and not forecasting which asset managers will be this year's best performer. Also review how the fund did during more volatile times and if capital losses were reduced.

Capital gains tax: Blom says these funds provide a solution to capital gains tax when portfolios are re-blended. If, for example, there are uncertain markets ahead and the broker wants to move their clients out of equities and into fixed interest, they could incur capital gains tax when selling units in a fund. If structured within a fund of funds there is no capital gain implication. However, capital gains tax does ultimately have to be paid and this is only deferring the tax. One also needs to decide whether the additional annual fees and the impact this has on returns justifies the tax benefits.

Revealing the real costs: Ask questions and make sure you fully understand the costs before signing on the dotted line

When selecting a fund, do not just rely on the published "annual fees" described in the fact sheets. These fees only disclose the fee charged by the fund of funds manager and not the total costs of the underlying funds.

Look at the total expense ratio (TER). This is available on the ASISA website. Click on Industry Statistics -- Collective Investment Schemes -- Fund Prices.

When reviewing TERs you need to understand what it includes. Class A funds typically declare an upfront maximum fee with a lower ongoing fee, while Class B or C funds may not have upfront fees but have higher annual fees.

For an investor it is more transparent to have an upfront fee that you can negotiate down, rather than a higher annual fee that is not necessarily declared to the investor. Over time the cost of that annual fee will start to add up significantly.

A high TER may indicate that the fund charges a performance fee. Understand exactly what the benchmark return is before the performance fee is charged and whether the manager is really sharing the risk.

The worst offenders: (information provided by Profile Funds Data online)
In the category of Domestic Asset Allocation Flexible Funds, which include both single unit trusts and fund of funds, there are 58 funds, and the best performing fund 36One Flexible Opportunity fund has a TER of 1,55%.

There are fund of funds in this category that have expense ratios (TERs) in excess of 2%, yet which deliver below average performance:
Absa All Rounder Fund of Funds: TER 3,50% and ranked 26/58
Avocado Fund of Funds: TER of 2,40% and is ranked 52/58
Carinus Strydom CS Fund of Funds: TER of 3,15% and ranked 39/58
Efficient Flexible Fund of Funds: TER 2,32% and ranked 41/58
Insight Capital Flexible: TER 2,57% and ranked 47/58

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