| Are Funds of Funds the Future of Wealth Management? |
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Funds of funds have always had rather a Cinderella reputation compared with direct investment in assets. Is this reputation justified? It would appear that funds of funds are very much getting in on the act, with a number of top private client managers launching them for their private clients. Recent examples include Barclays, Coutts and Towry Law. So why the sudden rush?
Managers are now realising these funds offer a triple whammy. They provide a ready means to enabling a multi-manager structure, they can cut costs and improve the profitability of the managers themselves and they are also more tax efficient for clients.
Multi-Manager
A multi-manager solution for wealth managers can be provided in two basic ways: segregated mandates (manager of managers) or fund of funds. With segregated mandates, the wealth manager hires an external manager specialising in a particular asset class or region to manage the assets. However, to work efficiently and provide sufficient diversity, segregated mandates need to have assets not far short of £1billion which is outside the scope of many wealth managers. In contrast, with fund of funds, a multi-manager operation can be set up with as little as £75m, arguably less if hard bargains are driven with the fund managers.
According to Lipper, the average fund of funds has out-performed manager of managers over 1 year, 3 years and five years. The reasons behind this vary, but the greater ease of moving in and out of underlying investments in fund of funds certainly has an impact, as, I suspect, does the fact that performance is published widely, therefore giving a bigger incentive for an investment manager to get performance from his funds.
One problem with the fund of funds model is the difficulty of finding a fund that matches the wealth manager’s exact requirements. However, if the wealth manager can provide seeding capital, fund managers are generally open to launching a fund to meet a particular set of requirements. Once the fund is launched, then it is available to other investors.
Costs and Profitability
The current economic environment means that wealth managers are trying to cut costs. The only really effective way doing this without affecting client service is to introduce a completely new, more efficient way of operating, which can be achieved by switching from individual portfolios to a fund of funds.
One of the biggest costs associated with wealth management is the dealing operation, but outsourcing this as part of the fund administration can have a dramatic impact on overheads. For instance, we recently dealt with a wealth manager using manual dealing and spending in the region of £50 for every deal placed. The costs were mainly due to the reconciliations and correction of the errors arising from the manual arrangement, rather than the dealing itself. By transferring the dealing operation to an external fund administrator with an automated process, costs were reduced to less than £6 per deal. The new structure also cut the number of client holdings and transactions, enabling the system to hold 10 times the number of clients, thereby extending the life of their portfolio management software.
In addition, outsourcing fund administration can also improve the investment management operation (see diagram). Rather than trying to track each client’s individual holdings, the investment manager sets up a model, with all investments and withdrawals following this model.
Operational Challenges
Setting up a fund of funds requires a range of tasks, from preparing the prospectus and gaining regulatory approval, which can take between 6 and 12 months, to deciding where the funds should be domiciled.
These days there a number of domicile options including the UK, Dublin or Luxembourg, with the choice affecting the tax position of the funds. The fund structure also needs to be considered – for instance UCITS status has marketing advantages, but can limit investment flexibility. The selection of the right administrator is also a key consideration and probably the most complex task to be undertaken given the huge variation in performance and cost.
Benefits to Clients
Despite the challenges, a fund of funds operation can transform a wealth manager’s costs base. Although some costs are passed on to clients, the savings made outweigh them.
Where a wealth manager charges an annual fee for portfolio management, this is liable to VAT. However the annual management charge of a fund is not liable to VAT. So if a wealth manager charges a fee of 1% p.a., the client will make a saving of 0.175% under a fund structure. Provided the fund admin costs are less than 0.175% then the client benefits. We recently set up some funds for a wealth manager where the fund admin costs were less than 0.1%. Clients effectively had their fees reduced by nearly 10%.
A fund structure is also more tax efficient as the annual fee is a capital expense when charged to a client portfolio, but an income expense when charged within a fund. In addition, the CGT position can be managed much more effectively with funds – a discrete portfolio of assets will generate capital gain and a possible liability purely through rebalancing, but a fund’s transactions are exempt from CGT. A CGT liability is only generated when the fund holding is sold, allowing for more accurate management of the client’s CGT position.
The fund structure allows holdings to be managed much more effectively for the benefit of clients.For instance, it is possible to negotiate rebates in the Annual Management Charge from external fund managers. These managers benefit from having just the one holding on their register and a much more efficient dealing process, and they can be persuaded to share these benefits.
We believe that funds of funds are the future, allowing wealth managers to introduce a multi-manager proposition which dramatically cuts costs and improves profitability while at the same time reducing client costs and tax liability. The results speak for themselves.
Mark Seaman
FusionExperience
As featured in Investment Adviser October 2008
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