CCS

More funds the better

Written by Andrew Holt, Melanie Wotherspoon and James Parker
October 2009



Melanie Wotherspoon looks at the attractions of a fund of funds
and multi-manager approach for the charity sector noting it offers diversification by fund group, investment style and asset class



As we slowly emerge from the second major bear market in less than a decade, the arguments for multi-manager investing have rarely been stronger.

These funds of funds are run by experienced teams looking across the whole investment industry, with freedom to use their selection of the best managers available, seeking to maximise returns for investors. Many allocate money across different asset classes - equities, bonds, property, cash and areas like commodities and hedge funds.

In the retail market, multi-manager investing has grown in popularity over the years, with the vast majority of major fund groups now offering these products as a key part of their range. With financial advisers facing a growing regulatory burden, many more are looking to outsource fund selection to professionals, suggesting multi-manager investing has considerable scope for further growth.

This brand of investing is also making inroads into the charity market. The major attraction of multi-manager funds is that they offer diversification by fund group, investment style and asset class.

No one fund house can realistically claim to be the absolute best in the market in every area and even the top-performing managers will suffer periods of bad performance from time to time. A fund of funds manager can look across all groups to find what they believe to be the best manager in specific areas, and switch between them depending on conditions.

Many critics argue that the difference in returns between a fund of funds and any well diversified vehicle with the same geographical and sector mandate is unlikely to be significant. But the basic argument remains absolutely clear - if you had the choice between buying all your clothes or food from one shop, however excellent, or the absolute freedom of the market, most consumers would opt for the latter.

Another key point to remember is that some of the most talented managers in the UK will only run funds rather than segregated mandates. So a multi-manager fund is often the easiest way for charities to access both asset allocation expertise and the underlying managers.

In terms of investment style, certain groups are known as growth or value houses and this effectively dictates the type of company in which they tend to invest. In certain markets it is better to invest with a growth or value bias.

So again, limiting your investment to one firm could restrict a portfolio to a single style, potentially curtailing returns if this approach is not favoured by the current market background. Fund of fund managers can blend investment styles to reduce this issue, moving between groups and managers depending on conditions.

This leads into the last key diversification benefit of multi-manager - diversifying by asset class. While the basic concept of allocating assets according to conditions�is easy to understand, these calls are notoriously difficult to get right and require extensive market experience.

Several academic reports down the years have shown this is the major factor in determining investment performance, with some claiming asset allocation is responsible for as much as 50% of returns. At Jupiter, our multi-manager team is renowned for its�active asset allocation and therefore any charities investing in these funds will benefit from this.

In general, multi-manager can be seen as a cost-effective product for the charity market, as it offers access to many of the industry's best known fund managers without requiring high minimum investments. Segregated mandates will often need a significant sum of money, whereas even the smallest charities can use multi-manager as a way into the premier groups and products.

That said, cost is one of the major arguments levelled against multi-manager as the vehicles carry a double layer of management fees - one set on the fund itself and another on the underlying holdings. Compared to buying individual lines of stock, as many charities have done in the past, multi-manager will have�lower dealing charges but may have a higher total expense ratio (TER). However, multi-manager TERs are publicised so investors know the cost implications. Of course being daily priced, the performance of these funds is easy for a charity to monitor.

In fact, the Jupiter Independent Funds team are totally focussed on adding value over and above all charges through an active approach to asset allocation and fund selection. The four funds of funds that we have at Jupiter are not suitable for a charity which may have specific income or SRI requirements, our charities team are able to create bespoke portfolios for clients whilst having access to the expertise of Jupiter's experienced fund management team including the Jupiter Independent Funds Team.

Melanie Wotherspoon is director of private client and charity business development at Jupiter Asset Management




Andrew Holt looks at the investment approach and arguments surrounding funds of funds and multi-manager


With the severe recession still on the minds of all charities and the financial world in general, an investment approach that can offer diversification to reduce risk while offering healthy returns could be viewed as an ideal form of investment.

It is therefore not surprising that fund of funds (FOF) and multi-manager, as it also known, is becoming an increasingly popular form of investment for charities, as it uses an investment strategy of holding a portfolio in a range of investment funds rather than investing directly in shares and bonds.

Each fund may invest across different sectors and markets, or having managers investing in the same asset class but have different investment styles. Based on the theory that not all investment managers are good in all markets and that not all managers are successful at all times.

Spreading the investment across different asset class or markets allows,
in principle, the investor to achieve diversification and reduce risk without sacrificing the return. Many investment managers have proved this has been a successful philosophy.

Furthermore, there are products to suit every taste: from the cautious, with a heavy focus on bonds and cash, to say a tactical portfolio with no constraints. Fund of funds provide something of an attractive 'one stop shop' or core holding for portfolios, especially for smaller charitable funds in the region of £100,000 to £3million.

Diversified portfolio

Fund of funds offer the best way to achieve, a in a straightforward manner,
a diversified portfolio of leading fund managers, continually monitored by a lead manager. This can bring them the benefits of different approaches
to investment.

On this, John Redwood, chairman of Pan-Asset Capital Management, says: "When one or more of the strategies goes wrong, one of the others might work. Even in 2008 when private equity, property, and quoted equity of most
kinds went down all round the world, a government bond portfolio made money." James Parker, managing director of Charity Business Financial, confers: "Fund of Funds offer simplicity, ease and diversification in one package".

A use of qualitative and quantitative analysis set against a management team's views on the macroeconomic backdrop has an impact on the investment. In simple terms, a manager may assess the outlook for the global economy and how it will affect stock markets, then assess which fund managers will produce the best results for that world view.

Parker adds: "However, the trade off is diversification at two different levels - a range of different asset classes, and also different fund managers. The fund is not reliant on just one key or star fund manager. Well run fund of funds can therefore offer the opportunity of reduced volatility and higher returns."

Charity discounts
A typical Fund of Funds will have an overall management cost, excluding
any adviser discounts, of about 2% to 2.3% per annum. This is approximately 0.9% or 1% more than the average unit trust fund. Further discounts for charities may though be achieved depending on the amounts to be invested.

Charity Business Financial rates the Jupiter Merlin Portfolio (see page 31). It is available with a minimum lump sum investment of £5,000 per portfolio. In this portfolio, charities can choose the amount paid to each month or quarterly. Key to its success is the stability of the investment team, who have been together a number of years. John Chatfeild-Roberts is head of the Jupiter Merlin team, Peter Lawery joined him in 1997 and Algy Smith-Maxwell completed the team in 1999.

Supporting the case for funds of funds, William J Bertin and Laurie Prather in their paperThe influence of management structure on the performance of fund of funds, note: "In terms of management expertise, FOFs enable investors to access foreign funds and create portfolios of top-quality managers whereby investors gain from embedded and affordable advice. Managers also have greater flexibility in reacting to changing market conditions due to the unique composition of FOFs."

Finance theory
It is FOFs ability to provide access to top quality managers and achieve risk reduction through fund manager and fund company diversification that are at the heart of advocates of the approach.

Bertin and Prather note: "Our results suggest that FOFs do offer diversification benefits to investors at both the fund company and manager level, and FOFs perform as well as, and in some cases better than traditional equity mutual funds with similar investment objectives. Management expertise influences performance since FOFs with identified team managers perform better than those FOFs with unidentified teams."

Finance theory would suggest that by holding a portfolio of funds with different managers, poor performance by one manager can be offset by another's good performance. Along these lines, Fant and O'Neal (1999) in their paper Do you need more than one manager for a given equity style? document substantial risk reduction benefits associated with diversification across fund managers.

Although a similar diversification argument can be made at the fund company level, holding different companies' funds may also expand the range of investment opportunities.

Bertin and Prather note: "Theory further suggests that FOFs' managers,
in their capacity as monitors, reduce potential inefficiencies arising from agency problems between fund managers and fund owners. Thus, agency costs
(the added layer of fees and expenses) are borne by investors to compensate FOFs' managers for the oversight function they provide."

John Kelly, head of client investment, at CCLA, adds that the multi-maager approach offers something only a professional could do.

"Most fund managers can have attractive short-term records because of good fortune and they ebb and flow over a period of time. To understand people of who have real skills you have to study data over a long period and analyse that data to a level of detail no non-professional could do."

Cost complexity

Though some critics however, argue that the diversification is largely illusory. The difference between a fund of funds and any well diversified fund with the same geographical and sector mandate is very unlikely to be significant.

John Kelly at CCLA adds: "Investment managers [within funds of funds] should be complementary. It is a bit like choosing a football team, no matter how many attractive left-wingers you can find, one is the about the right number, if you have a number of managers who do things the same way, you are not diversifying but combining the same bet. And when it goes wrong all the risk control you thought you had there is actually absent. So monitoring the managers is very difficult."

Though there are two main disadvantages to using lots of managers. The first is cost and complexity: more is spent monitoring them and meeting with them. They each need to charge charities percentage fees based on the amount of money they manage, rather than based on the full size of the total fund. This will tend to increase the fee.

The second is you can lose control over what really matters, the overall
asset allocation. If you are hiring good managers whose skills you rate, you will usually give them considerable discretion.

Andrew Wilson, head of investment at Towry Law, is critical of the whole process. "It is a fallacy that fund of funds has a track record in its fund selection and whether it really adds value. Fund selection is incredibly difficult, even for the professionals. I am not aware of any fund of fund manager who is able to credibly advertise a track record of consistent added value from this avenue.

"In fact, in many insistencies switches in their underlying fund managers
are value destroying. Furthermore we know that 90% of the variability in portfolio returns comes from asset allocation. Therefore it is more crucial that one feels that a fund of fund manager is strong at asset allocation - and Jupiter may be a rare example of this - than the red herring of fund selection, which the majority can't do, and makes little difference in any case to the overall outcome, other than adding cost. "

Backing this up, research from Cambridge Associates showed that newly hired managers had outperformed their predecessors by 11% in the year before the switch was made, but then underperformed by 4.1% in the subsequent year; questioning the switch.

And according to Amit Goyal and Sunil Wahal in their paper The Selection and Termination of Investment Management Firms by Plan Sponsors: "The opportunity costs [in multi-manager] are positive but with high standard errors. If one adds transition costs discussed in the introduction (say, 1.0% to 2.0%) to these opportunity costs, the overall costs of firing and hiring investment managers rise further. Moreover, if the costs associated with hiring and firing investment managers are important, then at the margin they should play
a role in retention decisions."

Though Bertin and Prather state: "FOFs differ in size, performance
and cost structure when compared to traditional equity funds. Particularly appealing to investors may be the higher returns and lower volatility and costs associated with FOFs. In spite of the added layer of fees, FOFs are able to absorb these and in some cases provide enhanced risk-adjusted performance."

Reduction in exposure
Though what can charities do with investment managers to improve, whilst maintaining the best of their managers? Redwood says: "We are now offering a strategic asset allocation advisory service, allied to investing a balancing portfolio for the larger funds, so they can regain some control over the overall asset allocation and cut the costs of active management on a portion of the fund.

"The active managers would not be asked to change their approach or their asset allocations, but would just keep us informed of any major changes that could affect the overall balance, so we could adjust if necessary."

Defaqto's analysis of Balanced Managed multi-manager funds undertaken in August gives an indication as to where the multi-manager industry is looking for returns. On average, there has been a reduction in exposure to UK fixed interest by a couple of percentage points, a jump in exposure to UK and European equities by some 6 per cent overall and marginal reductions in exposure to US and Asian equities.

Moreover, Jupiter's fund of fund investment note, states: "Much of
the easy money has already been made in equities and markets no longer appear as convincingly undervalued but we would like to highlight that in the markets' fervour to buy 'beta', meaning stocks highly correlated to movements in the index, it has arguably left behind the very stocks that we feel are best positioned to thrive in the much more challenging environment. This is a view that is strongly supported by the underlying managers of the Jupiter
Merlin Portfolios which gives us confidence for the future."

John Redwood observes: "In recent months we have favoured substantial investment in Asian and emerging market equity, usually placing around one third of the portfolio in such markets. In 2008 we recommended extreme caution, and would have usually suggested 100% of the balancing fund being in money market instruments or on deposit or in short-dated bonds."

Though, as in other forms of investment, managers change, in both bad times and good. Since identified teams may be directly responsible for the FOFs' performance, their reputations are naturally at stake. This provides the motivation to use their management expertise in selecting fund managers
and fund companies, as well as evaluating the economy, industry and firms in which the selected funds invest.

Bertin and Prather state this an important part of the process. "We find enhanced performance for these identified team managers who provide more than naïve diversification. In contrast, fund companies that offer funds with unidentified managers may be attempting to capitalize on the demand for FOFs by creating a product that simply combines their existing funds.

In doing so, these FOFs merely offer naïve diversification with no specialized management expertise, and their performance is significantly worse."
Baer, Kempf and Ruenzi in their Team management and mutual funds, (2006) find a negative relationship between team management and fund performance, however, they do not differentiate between identified and unidentified teams.

In conclusion, Bertin and Prather state the positive outlook for FOFs is justified. "The findings [from their report] suggest that the rapid growth in FOFs
is warranted, since their performance compares favorably to that of traditional mutual funds, and they provide a cost effective method for diversification.

"Our results further indicate that enhanced performance can be attributed to diversification across fund managers, management expertise and cost efficiencies as opposed to fund company diversification."


Fund returns

James Parker says even some of the best large charity segregated investment portfolios struggle to match the leading fund of fund investment approach

Fund of Funds come in various formats, but many charities will be interested in the 'Cautious Managed' fund sector, which can offer income and growth in a risk controlled manner.

Jupiter's Merlin Income portfolio is just one fund that fits into this category and has a long track record so a comparison can easily be made between the average Cautious Managed fund sector over different periods of time.

This is especially important as one of the main disadvantages of a Fund of Fund is cost, as the investor suffers charges from the lead fund manager and also the underlying fund managers.

Charity Business Financial, who specialise in advising charities, favour Jupiter's Merlin Income portfolio as an excellent example of a well run Multi Manager Fund of Funds.

The fund's consistent performance and out-performance of the Cautious Managed fund sector, shows that taking this approach can pay off. Over a five year period until 22 September 2009, Merlin's Income fund produced an annual return of 7.28% which compares very favourable to the sector average of 3.96%.

Even over the last year (to September 2009) where equity funds have rebounded in recent months, the fund has shown superior returns of 8.77% compared again with the sector of 3.79%.

Jupiter's Income fund currently offers an historic yield of approximately 3.8%. This level of income will meet many charities requirements - however, some charities who may wish to take a Total Investment Return approach can also receive a monthly income from the fund under an automatic encashment procedure.

This would allow trustees to receive payment out of the fund equivalent to say 5%. Therefore the ease of management of the fund, especially for a smaller charity, makes it a useful fund.

Charity Business Financial says it would be easy to supplement this holding with satellite holdings in equity index funds or specialist common investment property funds for increased diversification, if the trustees so wished.

For ease of management trustees can also access these funds via 'investment platforms' or 'wraps' to assist with their record keeping and general ease of management, often burdensome for the smaller charities.

Larger charities can obviously access the specialist charity teams from the leading fund management groups, but smaller charities with monies to invest for the long term will find this an excellent way to obtain top quality investment management advice.

Even some of the best large charity segregated investment portfolios struggle to match the leading Fund of Fund unit trust investment approach as offered by Jupiter or Henderson, who can show consistent performance against the Cautious Manager sector over a long period of time.

James Parker is managing director of Charity Business



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