Exponential Diversification

'Fund of funds' provide extra protection for investors whose priority is diversification.
Author:
Publish date:

For some investors, the diversification provided by mutual funds simply isn't enough. Some want an extra layer of protection.

That's why a number of fund families offer "fund of funds" to achieve even greater diversification than traditional mutual funds. Fund of funds are mutual funds comprising shares of assorted mutual funds.

The $2.2 billion

(PRSGX) - Get Report

T. Rowe Price Spectrum Growth fund, for example, invests in eight T. Rowe Price stock funds. The $50 million

(KOGRX)

Kobren Growth diversifies across fund families and currently holds a blend of 12 funds in its portfolio.

The success or failure of all those layers of diversification is ultimately reflected by the fund's Net Asset Value, or NAV. Nevertheless, individual investors can find helpful hints by searching beneath that all-encompassing number to learn how the professionals running fund of funds are making their fund selections and allocating their assets.

Fund Selection

Kobren Growth's blended portfolio of 12 stock and bond funds may seem like an awful lot of diversification insurance but, like most fund of funds, it's designed to be a "one-stop shopping" vehicle for investors. And in those terms, even 12 funds is not that large a number when you consider the effects that one major fund catastrophe would have on the portfolio. This concentration of funds means that portfolio managers need to select their component funds with great care to avoid potential landmines.

Since the majority of fund-of-funds offerings are composed of mutual funds chosen solely from the same fund family, it's tough to glean too much from their choices.

(That's not to say a lack of choice threatens the quality of funds like the

(FFFAX) - Get Report

Fidelity Freedom Income fund,

(VGSTX) - Get Report

Vanguard STAR fund and the T. Rowe Price Spectrum Growth fund. In fact, all three are highly rated by Morningstar.)

But by peeking into the funds held by managers left free to scour the fund universe, investors can gain some valuable insights. Like equity fund managers who are paid to pick stocks, fund-of-funds managers are paid to pick funds, so they have a vested interest in doing their homework.

For example, Rusty Vanneman, co-portfolio manager for the aforementioned Kobren Growth fund, says he whittles down the potential candidates by using the "5 Ps" that he defines as: people, philosophy, process, portfolio and performance.

"We look for the best people, in terms of managers with clear philosophies, in terms of their objectives. By process we mean a strong buy/sell discipline," explains Vanneman. "In terms of portfolio, we want to see how a fund is positioned relative to its benchmark. And when we judge performance, it's not about short-term sector bets. We search for long-term performers."

The result of Kobren's "5 Ps" elimination process is a blend that Morningstar analyst Gregg Wolper says "typically includes outstanding offerings managed by superior portfolio managers."

(Note that Vanneman and fellow fund manager Eric Kobren are formerly of Fidelity and still maintain strong ties to the firm. So there is usually a Fidelity fund or two in the mix.)

The American Association of Individual Investors, or AAII, a not-for-profit investment education organization, offers its own model fund portfolio as well as insight into its screening process on its Web site,

www.aaii.org. The AAII says its model mutual fund portfolio serves to "illustrate -- in real-world circumstances -- the approaches that an individual investor, rather than an institution, should follow." (See the chart below.)

Nine Is Enough
Individual Investor's Model Fund Portfolio Rules

Pure no-load fund.

In existence for at least 10 years.

Higher returns than the S&P 500 index on both an absolute and risk-adjusted basis for the most recent five-year and 10-year periods.

Can't have been down for two calendar years in a row.

Never have had a three-year period with negative returns.

Primarily a domestic common stock fund, although it may have some other investments in its portfolio.

Net assets of less than $2.5 billion.

It must have an expense ratio of less than 1.25%.

Currently open to individuals.

Source: AAII

Investors may not be able to trade the AAII portfolio exactly like a fund of funds, but those who have piggybacked on their picks have outperformed the

S&P 500

by 4% this year as of April 30.

Asset Allocation

According to numerous studies, asset allocation can play even more of a role than stock picking, when it comes to an investor's overall performance. And if an investor is putting his entire financial future into one big basket composed of different funds, he wants to make sure that he is getting the best possible asset allocation between various types of stocks, bonds and cash.

Investors hunting for clues on asset allocation can also take their cues by checking into the breakdown of prominent fund of funds. (Investors allocating their assets with an eye toward a particular retirement date might want to check out

life-cycle funds.)

For example, the objective of the $9.5 billion Vanguard STAR fund is to provide long-term capital appreciation and income. The fund maintains a static allocation of 62% stocks, 25% bonds and 13% short-term investments, or what can be considered a relatively standard breakdown for a conservative investor.

Deconstructed a bit further, enquiring minds can see how the portfolio manager breaks down the 11 component funds into different asset classes -- from the heaviest weighting of 16.2% in the large-cap value

(VWNFX) - Get Report

Vanguard Windsor II fund, to the smallest weighting of 4.2% in the small-cap

(VEXPX) - Get Report

Vanguard Explorer fund (see chart).

Not all fund of funds, however, maintain static portfolios. Ned Notzon, portfolio manager of T. Rowe Price's Spectrum line of fund of funds, says he holds regular meetings to tweak his asset allocation if need be.

"When we designed the funds, we designed neutral weights compared to the overall market. Everyone on the committee would be delighted to leave it at the neutral weights, because we think that's the sound, long-term thing to do," says Notzen. "We nonetheless meet every month because we want to look at the performance and be certain that the portfolios are behaving the way they should behave."

In the equity-based Spectrum Growth fund, Notzen says he is currently overweight mid-caps relative to the Wilshire 5000. And he plans to trim his position there, as well as in the small-cap sector, which did very well for the fund last year. "We're not worried about the sector," says Notzen. "But we're probably moving a little bit of money from small-cap to large-cap at this time."

In the bond-based

Spectrum Income Fund

Notzen is overweight non-dollar bonds in the

(RPIBX) - Get Report

T. Rowe Price International Bond fund on the view that the dollar is more likely to weaken than strengthen over the next 12 months.

Notzen does not feel confined by only being able to choose from T. Rowe Price funds for his Spectrum line of funds. In fact, he views them as a "free diversification service" because the expense ratio for the Spectrum funds is zero. Spectrum fund investors pay the expense ratios for each of the component funds instead of being charged for the fund of funds.

"So it's just as if you invested in those funds yourself and called me every time I was making a change and I told you what it was," says Notzen. "If you mimic my changes, you'd have the same investment returns that we do."