Funds of Funds Have Lost Luster, But Still Have a Place

Yes, some mutual funds invest only in other funds. It was once a hot concept.
Author:
Publish date:

Can a stock mutual fund buy shares in another mutual fund? Is there a mutual fund that buys only the best funds? --Bob Spang

Bob,

In the mid-1990s, mutual funds that invested in other funds were happening products.

Now, these so-called funds of funds have drifted into relative obscurity.

But their usefulness as diversification vehicles remains valid for many investors.

Funds of funds can invest in the funds of a single family or they can draw from the wide, wide world of funds.

Some are constructed to provide an asset allocation among stocks, bonds and cash, providing a balanced portfolio from a single purchase.

The

(VGSTX) - Get Report

Vanguard STAR fund was one of the first of these funds to appear in the mid-1980s, and it's still around. This $7.5 billion portfolio invests in 10 other Vanguard funds -- including

(VWNDX) - Get Report

Windsor,

(VWNFX) - Get Report

Windsor II and

(VPMCX) - Get Report

Primecap -- and has its assets in stocks, bonds and cash.

Others will invest in the favored mutual funds picked by a portfolio manager. These funds are designed to give your portfolio a stake in some of the best-performing mutual funds available (in theory, anyway.)

The

(MMAGX)

Markman Aggressive Allocation fund has its money in 10 popular funds, including

(RYOCX) - Get Report

Rydex OTC,

(MNNAX) - Get Report

Munder NetNet and

(JAVLX)

Janus Twenty. (The Janus fund is closed to new investors but you can still get a piece of it by investing in this fund.)

Either way, the portfolio manager will be constantly evaluating the mix of funds in your fund, tweaking the allocation and sometimes dropping poorly performing funds and adding new ones.

The real growth spurt for these products happened in the middle of the last decade when dozens of these funds appeared. For a while, they looked like the perfect investment product.

In 1996, funds of funds as a group took in $4.3 billion in assets, according to

Financial Research

in Boston. In 1998, that amount had climbed to $6.3 billion, but last year these funds collected just $5.4 billion.

All in all, funds of funds commanded about $43.4 billion in assets at the end of January, a paltry amount when compared to the $232 billion in

S&P 500

index funds.

A few things happened to make these funds seem less attractive.

For one, they came under fire for their high expenses. A fund of funds can carry two layers of fees -- and many do.

First you'll pay the average weighted expense ratio of the underlying funds in the portfolio. On top of that, the company that constructed the fund of funds might charge you for the actual fund selection or asset allocation.

For example,

Charles Schwab

charges 0.5% annually for its

MarketManager

portfolios on top of the underlying funds' expenses.

Markman Capital

charges 0.95% annually for selecting the funds in its four portfolios. Several funds charge well over 1% a year just for fund selection.

Vanguard is one exception, charging you nothing for bundling funds together in its multiple-fund products like the STAR and

LifeStrategy

funds. You only pay the average expense ratio for the funds in each portfolio.

T. Rowe Price

doesn't add any fees to its

Spectrum

funds either.

When you look on the

Morningstar Web site at the expense ratio for funds of funds, you'll find only the top layer of fees. You won't see the average weighted expense ratio of the underlying funds in each product. For that, you'll have to contact the fund firm. However, some fund companies, like

Fidelity

and Vanguard, do include the average expense ratios on their Web sites.

Now let's look at performance. For many of these funds, performance hasn't been good when compared to the rest of the market. That comparison, however, is unfair. Market returns have been driven by blazing tech stocks, while many funds of funds are balanced portfolios.

Many have their assets dispersed among stocks, bonds and cash. So you can't expect supercharged returns.

Compared to a portfolio that's heavy in tech, a fund of funds with 65% of its money in bonds isn't going to seem sexy.

"Investors often make inappropriate comparisons to growth or tech-heavy funds," says Morningstar analyst Frank Stanton.

Actually, you can't even compare funds of funds to one another. Their objectives vary dramatically.

The Markman Aggressive Allocation fund, for example, is a large-cap growth fund with about 70% of its assets in tech stocks. Schwab's

(SWOSX)

MarketManager Small Cap is -- just that -- a small-cap fund. And many of these multifund portfolios are balanced funds (dividing assets among equity and bond funds), like the

(TIMAX)

TIAA-CREF Managed Allocation fund.

The best way to pick among these funds is to examine their returns and their risk levels and decide which is the best fit for you.

Many investors are perfectly confident in picking their own funds these days and don't want help doing it. Also, investors who use a financial adviser or a broker are already paying for advice and don't need to pay a fund company even more for picking a portfolio of funds.

These days, you can get an asset-allocation plan for a one-time fee of a few hundred dollars. Schwab, for example, charges $400 for a portfolio consultation by an investment specialist.

Despite the obvious flaws and limitations, buying a fund of funds is the cheapest and easiest way for some investors to start an investment portfolio.

"When you think about a lot of 401(k) users, who know absolutely nothing about the market, they really aren't going to be able to educate themselves in a month's time when they need to pick a fund," says Morningstar's Stanton.

If cost is a sticking point for you, Vanguard and Fidelity offer low-cost funds of funds constructed from their own fund families.

Vanguard's funds of funds are all very inexpensive. Its

(VASGX) - Get Report

LifeStrategy Growth portfolio has an average expense ratio of 0.29% and doesn't charge a top-layer fee for the asset allocation.

Fidelity's

Freedom

funds are constructed for varying retirement dates and only charge 0.08% a year on top of the funds' expenses.

If you have very little money to invest upfront, these funds of funds might also be worth a look. You can buy Schwab's MarketManager Small Cap fund with $2500 and you get 25 to 30 funds.

If you're looking at a fund of funds with what looks like a high top-layer fee, just multiply that charge by what you're investing. That's about what you'll pay over the next year. You may find it's a bargain compared to what you'd pay a financial planner. Then again, you may not.

If that's more than you want to pay for fund selection, you can always pick them yourself.

Send your questions and comments to

deardagen@thestreet.com, and please include your full name.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.