Mutual Fund Monday - Dagen McDowell

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Ins and Outs of Funds of Funds

Dagen McDowell

Please help me with this rather mysterious group known as funds of funds. Are there any in particular that have good track records? How do they vary? -- Kingsley Hooker

A fund of funds can be a great all-in-one investment, depending on what's in the fund and how much it costs you.

There isn't much that's mysterious about a fund of funds. The name really says it all. It's a mutual fund that invests in other mutual funds. These portfolios can invest in the funds from a single fund family or from the universe of mutual funds.

Some are designed to spread your money among stocks, bonds and cash. Others invest in a collection of funds favored by a portfolio manager. In theory, you're supposed to get a portfolio of top-performing funds. But these might be hot funds that are about to turn cold.

You need to return to the most basic questions you should always ask when buying a mutual fund: Does the fund own investments that I need? What's its record like? And how much do I have to pay for it?

First, let's talk about price. Some funds of funds aren't cheap. Many funds of funds can carry two layers of fees. You'll pay the average weighted expense ratio of the underlying funds in the portfolio. In addition, the company that put together the fund of funds might charge you for the actual fund selection or asset allocation. An added fee of just a few hundredths of 1% is acceptable. An additional charge of 1% every year is not.

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Be careful when you're looking up the expense ratio on a fund of funds. Morningstar's Web site will only show the top layer of fees -- any extra charge for fund selection or asset allocation. You won't find the average weighted expense of the funds in each portfolio. For that, you'll have to call the fund company or check out a firm's Web site.

And if you're looking for low fees, go to Vanguard. The (VGSTX)Vanguard STAR fund was one of the first funds of funds to appear in the mid-1980s. It's still around. It's still cheap. And it's still a good bet.

The STAR fund invests in 11 other actively managed Vanguard funds, including Windsor, Explorer and Primecap, and spreads its assets between stock and bond funds. Plus, Vanguard doesn't charge an additional fee on top of what the underlying funds charge. The average weighted expense ratio of this fund is a rock-bottom 0.37%.

You get a diversified portfolio with this one fund: exposure to both U.S. and foreign stocks. And its record is exceptional. The fund's five-year annualized return of 8.3% beats 85% of other funds that invest in both stocks and bonds.

If you're a fan of Vanguard's index funds, the firm offers four so-called LifeStrategy funds. These funds of funds also invest in both stock and bond funds, but they're primarily made up of index funds, which makes them even cheaper than the STAR fund.

If you're looking for a fund of funds that will change with you as you age, Fidelity offers six asset-allocation funds called its Freedom funds. These funds invest in other Fidelity funds and are designed to get more conservative the closer you get to retirement.

You simply have to match your retirement date to the number in the fund's name. The Freedom 2040 is for investors who are planning to retire in about 40 years and invests in 14 different Fidelity funds.

Fidelity does take an extra fee on top of what the actual funds charge. But it's only 0.08% a year.

These Vanguard and Fidelity funds of funds invest in both stocks and bonds and can provide a diversified portfolio in just one investment. Plus, they don't cost much to own.

But not all funds of funds are as conservative or as cheap. Charles Schwab charges 0.5% annually on its four MarketManager funds, in addition to the underlying expenses of the funds in each portfolio.

The (SWOSX)MarketManager Small Cap fund invests in about two dozen small- and mid-cap stock funds. But you'd probably be better off buying just one solid small-cap fund. For one, you don't need exposure to more than 20 small-stock funds. For another, the returns on this Schwab portfolio have been decidedly lackluster. Its three-year annualized return of 3.9% ranks in the bottom 5% of small-blend funds tracked by Morningstar.

Yes, this fund of funds makes it easier than going out and buying a bunch of small-cap funds. But no one would do that. Again, you have to ask yourself: Does the portfolio hold funds that you'd buy for yourself in the first place?