Predicting the end of funds of funds glory

Managers’ selection bias and their perceived lack of transparency will make it increasingly difficult for fund providers to justify going the fund of funds route. Akram Ben analyses survey results related to open architecture and risk management across Europe.

One of the most significant trends in European fund management over the past few years is the growth of funds of funds as investment vehicles. When Sector Analysis conducted the interviews for its European Investor Focus survey early in 2002, distributors were undaunted by the prevailing brutality of the markets and almost unanimously confident about the prospects for funds of funds. On the basis of our responses, funds of funds are expected to grow in all 10 countries surveyed. Belgium’s distributors expected 13 per cent growth in funds of funds. Funds of funds were anticipated to grow by 19–20 per cent in France, Switzerland and Sweden and at even higher rates in the other countries. The most optimistic distributors were in the UK, where funds of funds were expected to grow more than 100 per cent. Funds of funds are an important part of the relationship between fund distributors and ultimate investors. Including third-party funds and in-house funds, they can amount to significant portions of the assets managed by banks in France and Germany and Italian insurance companies. Easy packaging Funds of funds are an important aspect of open architecture – which our research shows is increasingly accepted across Europe – because they enable easy packaging of products sourced from a variety of suppliers. But a key message of Chart 1 is that the spread of open architecture is not the main factor driving the rise of funds of funds. Sector Analysis estimates that in four countries – Belgium, Germany, the Netherlands and UK – in-house funds account for at least 75 per cent of all funds of funds assets. We estimate the figure for the UK is as high as 99 per cent. Expected growth varies widely between these four countries. Except in Belgium, distributors in these countries are looking for higher than average growth in funds of funds. The obvious interpretation is that they are optimistic about funds of funds as a vehicle for promoting their own in-house funds and/or that funds of funds will be key to gaining market share. France is the largest single market for funds of third-party funds. Sector Analysis estimates 68 per cent of French funds of funds assets are invested in third-party funds. Undoubtedly the 20 per cent growth anticipated by French distributors has something to do with the spread of open architecture. It is a reasonable bet that the same is true in the Swedish and Luxembourg markets, where third-party funds account for just under half of assets in funds of funds. These vehicles have certainly become increasingly popular as the downturn takes effect. They are supposed to provide diversified access to a range of mutual funds, which can be adjusted if performance in any of the underlying funds drops off. But fund promoters who assemble funds of funds will find it increasingly difficult to justify the diversification levels required by investors if they continue to limit selections to their own in-house products. They will also find it difficult to justify additional fees charged for asset allocation, when the final objective is to select the company’s own funds. Sector Analysis carried out a survey in late 2002 to measure the extent to which fund providers are perceived transparent in the way they manage risk by fund distributors. A perception of non-transparency about the way risk is managed can be extrapolated to the general behaviour of the fund provider in its relationship with its distributors. Risk management tells about a firm’s investment process, which is used to assemble a fund of funds. Chart 2 shows that the UK and The Netherlands, the two countries that package fund of funds using predominantly in-house mutual funds, are also the countries where the measure of non-transparency is the highest. Indeed in both countries around 40 per cent of the respondents couldn’t assert their fund providers were transparent in the way they manage risk. Low scores If we include distributors unable to answer the question – which means fund providers could not make their case regarding transparency – more than a quarter of distributors in the UK, The Netherlands, Belgium, Sweden and Germany do not trust their fund suppliers. Apart from Sweden, these countries have also scored very low in the measurement of openness (to third-party funds) of their funds of funds assembling programme. Many of these respondents agreed that transparency in risk management is “of the highest priority” and that “a lot can be done to improve the current situation further”. One Dutch insurance company said: “There is a lack of transparent information about fund composition”. A German bank volunteered: “Fund providers try to keep the figures secret, in order to have greater freedom regarding investments.” Against the background of a rapidly maturing and consolidating investment market, the European funds industry is missing this opportunity to send a clear message of transparency and trust to investors, which is fundamental to the development of the funds of funds industry: more transparent prices and less biased selection process. If fund providers continue to heavily promote their own mutual funds through this channel, they will fail to deliver on an essential ingredient of funds of funds: managers’ style diversification. The fact that funds of funds have not managed to be widely accepted by US investors should probably lead us to expect that they might also lose their legitimacy in Europe (and probably disappear) as European investors become more sophisticated. Akram Ben, director of marketing, Sector Analysis, a research firm dedicated to Europe’s asset management industry