2/14/08

Funds of Funds -- The Good & Bad

Funds of funds are mutual funds that, instead of owning individual stocks, own other mutual funds. A couple of examples include Janus' Smart Portfolio Growth (JSPGX) and Vanguard Star (VGSTX). If you're thinking of buying a fund of funds, there are some things to consider.

The potential benefits of owning a fund of funds include

1. Diversification -- by buying one fund, you can automatically be exposed to bonds, various domestic stocks, and foreign stocks.

2. Access to funds that are closed to new investors -- often the most popular mutual funds aren't open to new investors. But if a fund of funds already owns the closed mutual fund, you can buy it through the fund of funds.

3. Lower initial and subsequent investments -- initial minimum investments of most mutual funds are usually $500 or greater. Most are usually greater than $1000. Subsequent investments are usually $50 or greater. With a fund of funds, you can own several mutual funds for a much lower initial investment. For example, let's say you'd like to invest in five mutual funds, whose minimum initial investments are $1000 each, and whose subsequent investment minimums are $50 each. To invest in all of them, you'll need $5,000 right away. To invest in all of them subsequently, you'll need $250. With a fund of funds that owns all five mutual funds, you'll only have to worry about the initial investment minimum and subsequent minimums for only one fund, which would most likely be lower, even though you'll own all five.

4. Easier to sell/keep track off -- With a fund of funds, you only have one position to worry about, which could be advantageous.

What to Watch Out For

Fees

You should of course avoid funds with loads and other transaction fees.

Funds of funds, unlike other mutual funds, have "hidden" fees. When looking at a fund of funds, you can typically see only the expense ratio and other fees of the fund itself--that is, the various expenses the fund charges you for its operation. What may not be readily apparent is that holders of funds of funds also incur the expenses of the funds in the fund of funds' portfolio.

For example, let's say the fund of funds holds five mutual funds. If you buy it, not only are you going to pay the fund of funds' fees, but you'll also pay the fees of each fund the fund of funds holds. The fund of funds is sort of like a middleman through which you're buying the other mutual funds.

Possibly a Higher Turnover Rate

Another thing to consider about funds of funds is that in theory they have higher turnover ratios than most funds. This is because they incorporate the turnovers of each fund they hold (when the other funds sell stocks and buy new ones), and also have their own, when they switch allocations of the funds they hold. A high turnover rate can be a bad thing because stocks may be sold before their price fully appreciates, and you incur a capital gains tax (hopefully long term) when mutual funds sell their assets at a gain.

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For these reasons, if you have enough money, it is better to buy the funds individually than to have them in a fund of funds. By doing so, you avoid all the extra middleman fees from the fund of funds, and you have the added flexibility of choosing your own allocation of your fund holdings.

I myself hold a funds of funds, JSPGX mentioned earlier. I don't mind paying a little extra for diversification among stocks and bonds, and domestic and foreign stocks. I contribute around $50 a month. I wouldn't be able to do this if I held each individual fund separately. Moreover, some of the funds I have exposure to are closed to new investors, and for some of the funds I don't have the minimum initial investment.

I don't plan on keeping it forever, though. As soon as I have enough money to buy and regularly contribute to individual ETFs, I'll sell it and do that.

Index funds are probably a better alternative for most people. Their expense ratios are usually very low, as are their turnover rates. You won't beat the market with them, since it's the market whose performance they seek to replicate. But you won't underperform the market either.