Investec’s Aird: Will traditional fund of funds go the way of the dinosaur?

David Aird 160 byline

“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.”

How right Charles Darwin was and how relevant his clear thinking remains to the ever-changing complexities of modern financial markets. Since the early 1990s, traditional fund of funds businesses have slowly built up an increasing market share within the IFA world as an ‘off the shelf’ solution for those advisers wishing to outsource part or all of their investment management.

In general, this decade was kind to investors as major governments around the world eased interest rates to fuel their economic ‘miracles’, cut rates in Europe to allow monetary union and investors started to make real allocations to higher-growth emerging markets.

Rising stock markets are good news on many fronts, not least for those manufacturers which by design or by history carry higher than average charges.

Perhaps in the early 1990s many of us were not using the phrase ‘total expense ratio’ or the acronym TER, but all of us would have been aware of the corrosive force of high charges over a prolonged period of time on the value of a client’s portfolio.

There is an old saying, ‘all boats rise with the tide’, and throughout the 1990s, positive stock market returns would have powered a significant number of fund of funds returns with little or no additional ‘alpha’ coming from their manager selection or asset allocation decisions.

If we wind the clock forward to 2012 and look at stock market returns, we can see that many of the bourses have returned flat or negative returns over the past 10 years. Often, traditional fund of funds solutions have not had the market beta to bail them out in the eyes of the investor and poor returns have been further reduced by unsustainably high TERs.

With the RDR implementing huge change in the industry, the like of which has not been seen since 1986, investors will now benefit from the unbundling of charges, greater transparency of costs and a real focus on value for money.

In this environment old-fashioned fund of funds products will struggle to survive, with TERs in some cases of 2-3 per cent. Instead, a contemporary and professional approach to creating managed solutions for clients has to come from a well-resourced multi-asset team of fund managers who are not restricted by traditional fund of fund structures or thinking.

Multi-asset teams have two main drivers for generating returns: asset allocation decisions and funds or instrument selection to express these views. A hybrid model appears to be an optimal design for a managed solutions fund as this has the ability to use low-cost passive instruments to allow the manager to access cheap beta, while at the same time leaving room for more expensive funds or instruments to generate true alpha opportunities.

The blending of active and passive vehicles allows the manager to deliver a TER to the end investor closer to the 1 per cent mark, which in an unbundled world is significantly more attractive than those posed by the old fashioned fund of funds.

Another significant benefit of contemporary multi-asset solutions such as those described above is the opportunity for the advisers and clients alike to benefit from portfolios containing truly uncorrelated assets.

The leading thinkers in this area are accessing infrastructure, physical commodities and specialist bond issues to build sensible and diverse portfolios which hopefully will not repeat the problems that some of their traditional fund of funds competitors suffered during the financial crisis.

As we fast approach the start of a new era in financial services and herald the arrival of an unbundled post-RDR world, you will no doubt be giving a thought to the best way to access multi-asset solutions for your clients.

Costs have always mattered, and in a low interest rate, low growth environment, TERs will be on everyone’s agenda. A focus on value for money should prevail, and while the industry has moved on, some of the products out there have not.

So perhaps we should edit Darwin’s words and align them more closely with our own industry to read: “It is not the cheapest of the species that survives, nor the most expensive that survives. It is the one that is the most adaptable to change.”

David Aird is managing director, UK client group at Investec

Advisers’ views

Mark Dampier, head of research, Hargreaves Lansdown

It’s true that higher fund charges may come under pressure once the RDR is implemented – indeed some of the industry has suddenly had a Road To Damascus conversion to passive/low charges, but in many cases this has more to do with IFAs seeking out a cheap solution so they can put their usual charges on top. It is no surprise that new funds might appear that are cheaper, multi-asset-type offerings that can do all sorts of wonderful things like turning lead into gold, but they will still only be as good as the people who run them. So far I have seen lots of clever managers make all sorts of bad asset allocation decisions, like shorting the gilt market over the past three years.

These cheaper funds will have to prove their worth, but cost is only one aspect of the investment equation, giving a multiple amount of ammunition and armour is no guarantee of good investment, in fact given all the decisions that need to be made, the likelihood of something going wrong must be high. I would suggest a simple design fund of funds will still very much have its place. The industry has far too many over-engineered products, so be careful what you wish for.

Gavin Haynes, managing director, Whitechurch Securities

Gavin Haynes

Where advisers are outsourcing they are expecting the portfolio manager – whether it be discretionary or fund of funds – to be taking responsibility for asset allocation as well as fund selection. That move is happening – if you look at the groups taking money in the fund of funds space, such as Jupiter, their processes are driven by asset allocation as well as just selecting the best funds within a certain marketplace. Costs also come into the equation as people will expect more for their money, such as value added through asset allocation rather than just double the charges to buy a UK or European equity fund. Fund of funds that operate in single areas of the market will struggle as multi-asset funds continue to grow in popularity.