Two minds, or more, are better than one.
That seems to be the prevailing thinking these days, with investors flocking both to sub-advised funds and multimanager investments. Assets in both types of vehicles are growing at a far more rapid pace than internally managed mutual funds, according to two recent studies.
Cerulli Associates of Boston estimates that global multimanager assets totaled $489 billion at the end of last year and have grown at a compound annual growth rate of 15% since year-end 1999. Mutual fund assets worldwide, in the meanwhile, were nearly flat. Cerulli expects multimanager assets to surpass $1 trillion by 2007.
Meanwhile, annual asset growth for U.S.-based sub-advised mutual funds for the five-year period ending in 2001 exceeded internally managed funds by an average of 8.7% a year, according to Financial Research Corp. (FRC) of Boston. Assets in U.S.-based sub-advised funds, excluding money market funds, will reach $683 billion by 2005, up from $434 billion at the end of last year, according to FRC.
More Choices
Both companies cite the growing trend toward open architecture - the move by financial service providers to offer investors a wide variety of investment choices, and for growing investor interest in diversification. The FRC study indicated that at the end of last year, one out of every eight U.S. mutual funds was sub-advised.
However, both also say that study results don't necessarily mean that either trend will dominate the U.S. mutual fund industry.
"I don't think you will see [sub-advising] getting into a much higher range," said John Benvenuto, a senior consultant with Financial Research. "I don't expect it to get to one in four. I see it closer to one in seven, or one in six."
Benvenuto said that certain classes of mutual funds are not typically sub-advised, such as money and bond funds. The most heavily sub-advised objectives at year-end were government, U.S. equity and international equity, the study said.
Cerulli's study of multimanager assets included both fund-of-funds and manager-of-managers structures. With manager-of-managers arrangements, managers are hired, each to perform a segregated, specialized investment task. The largest global manager-of-managers is believed to be Northwestern Mutual subsidiary Frank Russell Co. of Tacoma, Wa. Fund-of-funds, by contrast, are made up of shares in other mutual funds.
Even though there seems to be more fund-of-funds, Haneen Rabie, the primary author of the Cerulli Associates study, says she doesn't expect the U.S. funds market to drive growth in this type of investment. In the United States, she said, fund-of-funds generally are lifecycle funds offered through major fund groups, like Fidelity Investments of Boston.
But there is a major opportunity, she stressed, for U.S. investment companies to take advantage of the trend internationally. In Europe, multimanager products tend to be balanced funds, largely offered by consultants and banks to less-experienced investors.
"One of the key needs that European fund-of-funds [address] is a simple balanced portfolio," Rabie said. "The multimanager concept is very appealing to these investors because advice is embedded in the product itself. You don't need an adviser to choose the product for you."
Internationally, Rabie said, fund-of-funds can charge up to 1.5% to 2% of assets on the underlying funds and the same fee on the overarching management fee. There also may be a front-end load, which typically runs between 3% and 5%, she said.
Manager-of-managers programs are less costly. The total, including the underlying and overarching fee, runs 2.5% of assets, she said.
Nevertheless, global fund-of-funds' market share, the Cerulli report said, soon will outpace the market share for manager-of-managers programs. Fund-of-funds' marketshare of overall multimanager accounts, now 47%, will swell to 62% by year-end 2007, the reason being that fund-of-funds are more profitable and easier to build.
International investors are undereducated about fees compared with U.S. investors, Rabie explained. In the United States, managed accounts already dominate, and fund-of-funds won't be popular if there is double charging.
Another factor accelerating the international trend to fund-of-funds, according to the study, is the European Union's Undertakings for Collective Investments in Transferable Securities (UCITS) guidelines.[see MFMN 5/20/02]. The series of guidelines allows fund managers to cross-register fund-of-funds for sale in multiple countries.
Rabie advised that U.S. mutual fund companies seeking to offer fund-of-funds need to look for duplication and leverage their size.
Be aware that performance screens alone aren't sufficient in figuring out how to combine the best managers and best funds, Rabie said. It is critical to determine, for example, whether the underlying managers are duplicating each other's holdings.
Larger fund promoters need to use size as a negotiating tool with underlying managers to knock down fees.
Rabie also warned that smaller fund groups seeking to expand their share by offering multimanager programs abroad need to be aware that the cost can be high.
With a sub-advisory arrangement, according to Financial Research, sub-advisors typically receive 50% of the advisory fee paid by the fund to the advisor. But the report said there is debate if this actually raises fees to investors. The largest employer of sub-advisors, Vanguard of Valley Forge, Pa., which hires the nation's largest sub-advisor, Wellington Management of Boston, also is the most cost-effective fund company.
The FRC report also cites growth of sub-advised arrangements with brokerage firms, the proliferation of multimanager accounts and the launch of new sub-advised product lines by companies like AXA of New York, American Express of Minneapolis and Oppenheimer of New York.
Benvenuto said it's tough to find a downside to sub-advised relationships. Investors have an opportunity to get the best managers for a particular portfolio or style. It also presents opportunities for both the sub-adviser and manufacturer to grow relationships.
On the distributor side, however, it needs to be clear which fund takes precedence in the selling process. And hiring firms need to show that they're adding value rather than cloning an already existing fund and increasing expenses. Distributors must talk about their qualitative and quantitative selection criteria, he said.
Benvenuto noted that the sub-advisory market is institutional rather than retail. "Fund groups that embrace an institutional type of relationship with awareness that net flows ultimately are produced through retail support are going to do much better."
John Tobey, chief investment officer of the Vantagepoint Funds, an affiliate of the ICMA Retirement Corp. of Washington, said finding a sub-adviser is not easy.
He recently completed an exhaustive search to find new sub-advisers for some of his group's funds. Using a new consulting firm, Rocaton Investment Advisors of Darien, Conn., he said, he recently completed his lineup. But he had added two new criteria.
"We avoid recently acquired firms," Tobey said. "It's too hard to see behind the veil how acquisitions are going to change managers."
And Vantagepoint now also avoids managers with hedge funds. The conflict of interest is too great and there's no way for us to audit those conflicts."
