FUNDS OF FUNDS (FoF) investment solutions

Fund-of-funds investment solutions
We had carried an article on “Gold mining funds outperform ETFs in 2009”.
It mentions how two fund-of-funds — DSP BlackRock World Gold Fund and AIG World Gold Fund — outperformed both their benchmarks and gold prices.
The article seemed to have triggered investors' interest in the fund-of-funds structure; for several investors enquired whether such structure is optimal within a retail investment portfolio.
This article briefly explains the concept of fund-of-funds and shows why such structures are useful for retail investors.
It then discusses how the existing products can be used within the core-satellite portfolio.
Manager selection
Investors typically make sub-optimal decisions in their fund selection process. The reason is not far too seek. They are several style universe and too many funds in each such universe. This makes the fund selection process difficult.
A fund-of-funds helps investors reduce their selection error. How? Such a fund collects money from the investors and takes exposure to other funds based on the investment mandate. The fund selection process, therefore, rests with the fund-of-funds manager, who is expected to possess superior manager selection skills.
Now, global funds are offered to Indian investors through the fund-of-funds route due to regulatory reasons. Such funds, however, do not truly engage in manager selection as do typical fund-of-funds. The DSP BlackRock World Gold Fund, for instance, invests only in Black Rock World Gold Fund while AIG World Gold Fund invests in Falcon Gold Equity Fund, though the investment mandate allows both fund-of-funds to invest in other funds as well.
Alpha-beta conduit
The usefulness of fund-of-funds rests in the alpha-beta separation, which is a cost-effective portfolio construction process. The alpha-beta separation requires carrying two portfolios. The core portfolio carries low-cost passive (beta) exposure to index funds. And the satellite portfolio carries active (alpha) exposure to beat the benchmark index.
A typical diversified fund attempts to carry beta and alpha exposure within the same portfolio. That is, it carries large near-passive exposure to the market and some active exposure to the beat the benchmark index. The active fee is, however, charged on the entire portfolio- both the near-passive and the active exposure (see also this column dated March 29, 2009).
A fund-of-funds structure can offer investors the alpha-beta separation through a single portfolio exposure, containing index funds and alpha-generating active funds. The question is: Are fund-of-funds available in the market optimal investments within the core-satellite portfolio?
Core or Satellite?
At present, there are three categories of fund-of-funds. One category provides investors exposure to global markets. Examples are DSP BlackRock World Gold Fund and HSBC Emerging Markets Fund. The second category contains funds that invest within the family fund complex. Examples are FT India Life Stage Fund of Funds and Fidelity Wealth Builder Fund. The third category of funds invests in third-party funds and engages in broader manager selection process. Examples are ING Optimix Multimanager Funds and Quantum Equity Fund-of-Funds.
The second and the third category of funds help investors take exposure to a portfolio of funds. These funds, however, are not alpha-beta conduits. The reason is that they invest primarily in diversified funds, which are not suitable within the core-satellite framework.
The fund-of-funds that invest in the global markets suffer from the same problem. Yet, investors can consider exposure to such funds in their satellite portfolio; for this is the only route for retail investors to take global exposure to high-returns markets in their portfolio. The high management fee is, however, a deterrent.
Conclusion
Fund-of-funds is an elegant concept that can be used to custom-tailor investment solutions. Asset management firms can offer such products to enable investors construct low-cost liability-driven investments such as health-care and education portfolios. Existing products in this space are not optimally suited for the core-satellite portfolio, perhaps, with the exception of the ones that offer global exposure.