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‘Funds of funds’ offer simplicity, diversity

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Diversify your diversification.

Sounds mind-boggling, but that is the goal of "funds of funds." These are mutual funds that invest in shares of other mutual funds.

Such an all-in-one fund makes investing simple and is considered well-suited to beginning investors who don't have a lot of money to spread around. They achieve diversification and reduce volatility through one package of several different funds.

These usually include an assortment of stock and bond funds using a variety of managers and styles.

The folks who might frown on such a arrangement are those who don't consider themselves "average" at all and think they could do better by handling their own asset allocation.

"Funds of funds are for people who want to spread a small amount of money among several investment products," said Mark Salzinger, publisher and editor of The No-Load Fund Investor (www.noloadfundinvestor.com)in Brentwood, Tenn. "They prefer not to follow their investments as much."

The granddaddy of these funds of funds and a Salzinger favorite is the $13.7 billion Vanguard Star Fund (VGSTX), launched back in 1985. It invests in 11 Vanguard funds, keeping a stable asset allocation of 62 percent stocks, 25 percent intermediate- and long-term bonds and 13 percent short-term bonds. It uses six domestic stock funds, two foreign stock funds and three bond funds to accomplish this.

Star, down 4 percent this year, has a three-year annualized return of 8 percent and five-year annualized return of 11 percent. It features a low minimum initial investment of $1,000.

Its annual expense ratio is a low 0.32 percent. Vanguard and a number of other "no-load" (no sales charge) fund families don't tack on a second expense ratio to pay for bundling the funds.

Some other funds of funds have two expense ratios, one for the underlying funds and another for repackaging in the proper allocation. This is particularly true of those that invest in funds outside the fund family. That's why, since the beginning of 2007, funds of funds have been required to provide a breakout of direct and indirect expense ratios in their annual reports.

"Funds of funds are a great sales story, but we don't use them because it is hard to justify the extra fee layer many of them have," said Harold Evensky, certified financial planner with Evensky & Katz in Coral Gables, Fla. "I also believe that, rather than a 'one-size-fits-all' product that doesn't acknowledge different needs, most people are better off investing in several exchange-traded funds instead."

There is the question of whether you really want to own all of the funds packaged within the fund. Some fund families withhold their best products from their funds of funds, using the vehicle to attract money for funds that people aren't investing in on their own.

"Some funds of funds mean that investors accept mediocrity from a fund family," cautioned Tom Roseen, senior research analyst with Lipper Inc. in Denver. "The fund family can decide to either put its top funds in there or to put in some of its struggling funds."

The broad diversification of funds of funds makes it difficult to benefit from current trends that are providing a boost to a portion of the market or an investment style. They are rarely a hot investment ticket because they're intentionally headed in so many different directions.

"You're probably not going to find a fund of funds that blows off the doors in a particular year," said Greg Carlson, an analyst with Morningstar Inc. in Chicago. "Through diversification you're reducing the risks from portfolio managers leaving, but you could also potentially be diluting performance."

Some funds of funds focus solely on either stocks or bonds. For example, investors can receive exposure to all parts of the bond market with the $5.3 billion T. Rowe Price Spectrum Income Fund (RPSIX), which has performed well in the subprime mortgage crisis.

This no-load fund with annual expense ratio of 0.7 percent and $2,500 minimum initial investment can invest in as many as nine bond funds. It is up 1 percent this year, with a three-year annualized return of 6 percent and five-year annualized return of 8 percent.

A popular trend in funds of funds is the lifecycle fund. Also known as a target-date fund, it manages its allocations with a specific retirement date in mind and rebalances from aggressive to more conservative as retirement time nears. Many company 401(k) retirement plans include lifecycle funds.

An example is the $271 million American Century Livestrong 2025 (ARWIX), a no-load fund with an annual expense ratio of 0.85 percent and minimum investment of $2,500. This fund aiming toward the year 2025 has a portfolio of 61 percent stocks, 22 percent bonds and the rest cash. It is down 3 percent this year, with three-year annualized return of 9 percent.

One thing you won't find simple about funds of funds is comparing their performance. "You aren't really comparing apples to apples with funds of funds because they're investing in many different areas of the market and have different allocations," Roseen said. "Even if you compare them to funds in their own general category, it is not a perfect comparison."

Andrew Leckey answers questions only through the column. Address inquiries to Andrew Leckey, P.O. Box 874702, Tempe, AZ 85287-4702, or by e-mail at andrewinv@aol.com.