Research by Berlin-based fund research group Scope looked at more than 800 funds with at least a 10-year track record across four of its peer groups – conservative (up to 30% equity), balanced (40-60% equity), dynamic (at least 70% equity), flexible (0-100% equity). It found multi-asset funds that invest directly performed better than funds of funds in three of the four categories.
The biggest difference in performance was recorded in the balanced peer group where the nearly 100 direct funds achieved an average annual return of 5.5% compared with 4.6% for the 71 funds of funds. But in the dynamic category the average return between the two fund types was equal at 6.6%.
One reason for the inferior performance is costs are higher in funds of funds because of the additional level of management. The average additional burden ranges from 0.23% a year for the conservative category to 0.73% in the flexible category. Across all four peer groups, the average additional cost burden is 0.46% a year.
Difficult to compare
Rathbones’ multi-asset team switched from a multi-manager approach to investing directly about four years ago in order to be able to have greater control of risk and be more accountable for portfolio decisions.
But head of multi-asset David Coombs (pictured) told Portfolio Adviser it is difficult to compare investing directly in individual stocks with using underlying funds because it is not possible to say how the multi-manager portfolios he used to run would have changed in composition since Rathbones abandoned the model.
“There is no doubt when we were multi-manager we had £250m assets,” he adds. “We’re now £1.4bn and a lot of that’s probably driven by performance. I guess the anecdotal evidence would suggest it’s helped improve our performance, but I can’t prove that … because I don’t know what funds we would have bought.”
But Coombs says there is no doubt stripping out underlying manager costs associated with multi-manager has a direct impact on total expenses – and therefore performance.
“The added benefit going directly is you strip out something like 80-90 basis points of annual cost,” he says. “So, on day one you’ve added that to performance.”
Funds of funds have a wider performance spectrum
Despite the overall trend for direct funds to outperform funds of funds, Scope’s research found the latter had a higher top rating ratio than direct funds. In other words, in three of the four peer groups, funds of funds had a higher percentage of funds with a top rating ratio.
This was most evident in the dynamic group in which 37% of the funds of funds have a top rating, whereas direct funds have a ratio of 26%.
Scope head of communications fund analysis André Fischer told Portfolio Adviser: “The only interpretation of this is that you have many funds of funds that have a large underperformance, but some funds of funds perform very well. So the spectrum is quite large within the funds of funds world.
“But when we look at them together, on average, they perform not so well, which means there are a lot of funds of funds out there that show low performance.”
The research also found the difference in volatility between funds of funds and direct funds was comparatively low. It was only in the conservative category – the lowest risk – that funds of funds showed an average lower volatility of 3.5% versus 4.4% for direct funds.
Scope says it is surprising that despite perceived broader diversification, funds of funds offer hardly any significant advantages from being less volatile. The group says one explanation might be that, as a rule, direct funds already have broadly-diversified portfolios so further diversification through funds of funds adds little extra benefit.
Fischer adds: “Direct multi-asset funds have very broad diversification already. So, the advantage of even broader diversification of a fund of funds is not so immense.”
Closer to the securities
Coombs says investing directly also allows the asset owner to be more directly associated with the underlying securities. He uses the example of investing in US stocks which he and the team does directly.
“All those stocks we buy with an absolute return filter,” he says. “We’re thinking about the strength, their balance sheet and their longevity, we are not interested in short-term earnings numbers, we’re looking at longer term business prospects. If we allocate money to a US equity manager, they’re trying to beat the S&P every three months, they have a very different objective to ours.
“So, outsourcing doesn’t make a lot of sense for us. We’d rather buy directly. We can see the portfolio live all the time, so you know exactly what’s going on; your sensitivities, different movements. So you have a much greater risk perception. You have a pure way of following your views.”
Post-Brexit referendum changes
PGI Financial planning director Phillip Instone told Portfolio Adviser he has tried both methods: a globally diversified funds of funds solution with about 20 underlying funds; and using four outsourced direct multi-asset funds and a couple of specialist or growth funds.
What he found was prior to the Brexit referendum the funds of funds approach was the highest performing solution but since then the massive currency fluctuations have favoured a direct multi-asset approach.
He explains: “Post Brexit the market and the economic environment is so much more unpredictable. And so with the massive currency fluctuations, we’ve actually found that the [direct] multi-asset solution is a bit more resilient, and a bit more dynamic in between my reviews. When you’ve got 20 funds, you don’t change them or rebalance them on a daily basis, you do it every three or six months.”
Like Coombs, costs, speed of execution and proximity to the underlying assets also play a big role in Instone’s decision to opt for a direct multi-asset approach.
“I find that the costs are significantly lower in many cases. And also, you don’t get the dilution of decision making. In the multi-asset funds, you get one manager and they can make a decision to buy or sell stock tomorrow, or move from one sector to another.
“Whereas if you’re in a fund of funds, all the manager will do is buy and sell a fund to achieve their goal, but then that fund manager might then be operating within that in their own direction. So I personally find that [direct] multi-asset is a less diluted approach in both decision making and cost.”