In Europe, the fund of funds concept is taking off after years of indifference from private and institutional investors. There is now a realisation that a fund manager with the ability to cherry-pick the real star performers in a given sector can add substantial value to any portfolio.
In Germany, DWS, the retail funds arm of Deutsche Bank, has just raised around DM700m (E360m) for a fund of funds launch. Asset managers firms across Europe are now seeing much more interest in their fund of funds products, as opposed to the multi-manager hedge fund portfolios many of them have been majoring on, with mixed results, until recently.
The recipe for success as a fund of funds manager is in picking the strategies and managers that will be most effective in the market conditions that exist at the time. As such, a prospective fund of funds manager will need to demonstrate not just an understanding of funds per se, but also a knowledge and awareness of market conditions. And on the assumption that no one fund group has all the answers, the fund of funds manager must have the ability to choose from the entire universe and not just own-group funds.
Compared to US fund portfolios, the greater divergence between the best and worst fund performers in Europe and Asia means there is much greater scope for out-performance using a fund of funds approach. This is particularly true where the investment decision is supported by independent qualitative analysis of the funds universe. If you are investing in the top quartile, or better still top decile funds, on a global basis, then you are giving yourself a good chance of getting the very best returns. But it is not simply a case of looking at past performance figures.
A solid research function designed to monitor process, performance and style changes in the universe of funds, supported by regular contact with key managers, provides the basis for excellent investment decision-making. This approach ensures the right managers and the right combination of managers are chosen for a fund of funds.
As well as being able to introduce managers with particular geographical or sector strengths, the fund of funds manager can also introduce a blend of investment styles. Growth and value managers can both be accommodated in a fund of funds. For example, our approach to the US involves the combination of growth and value managers, with the emphasis on the former. This style combination provides a further level of diversification, which we consider important in managing portfolios in these areas.
There are some significant advantages associated with this approach. We have put our research process to the test as a manager of fund of funds portfolios. The ideal of a fund of funds is that you should be invested with the best of the best. The excellent returns we have been able to generate show clearly that there is significant outperformance to be gained by the use of qualitative analysis.
The concept proves effective in a number of ways. Firstly, in ensuring that we select the right funds, highlighting the benefits of fund selection combined with shrewd asset allocation. As an example, in the second quarter of 1999, while the majority of professional investors were steadily getting more confident about Japan, by staying close to the market and speaking to the managers, we were able to establish the right fund to maximise our exposure. We expected the yen to strengthen and following an endless number of economic bail-out packages by the Japanese government, we thought GDP numbers would be strong and therefore the best policy was to buy domestic small cap, high growth stocks vehicles.
Another way for a fund of funds manager to add significant alpha for investors is via liquidity analysis of global funds. The majority of global fund managers were underweight the US during 1999 and overweight Europe.
The more managers told us they didn’t like the US, the more we liked it, because in our view Europe was reeling from stuttering growth and a weak currency whereas the US continued to be the growth engine of the world.
Based on our liquidity analysis, by making the correct asset allocation decision and picking only the real star funds for our portfolios, we were able to produce significant outperformance. The concept of “applied research” works, and that is why the fund of funds concept is going to one of the major growth trends over the next five years.
Peter Toogood is a director at fund of funds specialist Forsyth Partners: