CHARLES Schwab Corp. recently gave up on the fund-of-funds concept. It's time that most investors follow suit.
A fund-of-funds is exactly what it sounds like: a mutual fund that invests its money into other funds, rather than stocks or bonds. The idea behind these offerings generally has been that they are a one-stop shop for investors who don't want the hassle of building a diversified portfolio of funds on their own.
There are two types of funds that buy other funds. There are the proprietary or "house" models, where a big fund company such as Vanguard, T. Rowe Price or Washington Mutual buys funds from within its own shop to build a diversified asset allocation. And then there are nonproprietary funds, such as Schwab's now-departed MarketManager funds - where the manager buys funds run by other firms.
It's this second genre that needs to be killed off. Since most firms that offer this junk aren't going the Schwab route and making changes, investors should do the job themselves and dump these losers.
The biggest issue dooming these funds is simple: costs. You're paying the costs not only for the manager who is running the fund-of-funds but also for the funds that person buys with your money. In other words, you're paying two layers of expenses and stealing from your own bottom line to do it.
The biggest selling point to funds-of-funds is convenience, the ability to achieve broad diversification and stability in one package. They are designed to be a hands-off type of investment for the investor who wants fund exposure without the work.
A basket of house funds can deliver that simplicity without being overwhelmed by costs. When a Vanguard house fund buys funds from within the company, it adds very little - and in some cases nothing - to the cost of investing the money.
Independent funds aren't so lucky. When the Markman Multifunds invest in, say, Fidelity Capital and Income, the investor must pay the freight for Markman's expenses in addition to paying Fidelity's management fee.
In Schwab's case, the MarketManager funds were converted to the Market Masters funds, where several money managers are hired to handle big chunks of money. This is a manager-of-managers approach, or a multimanager fund. Hiring managers as "sub-advisers" costs the fund less than the expense ratio it incurs investing in an outside fund, which makes the multimanager approach cheaper and more likely to succeed over time.
That's precisely why the number of multimanager funds is rising while the number of fund-of-funds is shrinking.
"The problem with fund-of-funds that invest outside of their own shop is that the managers seem to think that the only way they can add value and justify the extra expenses is to trade constantly," says Peter DiTeresa, senior analyst at Morningstar.com. "They wind up with a fund that looks and acts like a market timer - trading a lot trying to convince investors they're getting real expertise - which usually means that it's losing money."
Adds Avi Nachmany of Strategic Insight, a firm that tracks the industry: "I'm cynical whenever there's a manager who says 'I'm so brilliant at picking money managers that I can move your money around and optimize it and you won't even notice the extra expenses.' Most people just can't do it."
But that doesn't stop them from trying. Frequently, fund-of-funds are started by financial advisers looking to branch out (as is the case with Markman), or by newsletter editors trying to produce a product that lives by their investment advice (the Fund*X Upgrader, for example).
"It's an easy and good way for an investment adviser to get into the business," says Lipper Inc. senior research analyst Don Cassidy, "but that doesn't make it good for the customer."
Ultimately, performance is the issue, and only the "house" fund-of-funds have been able to provide consistent success. Meanwhile, there have been many fund-of-funds bombs, such as the Markman funds.
Markman is liquidating its income fund - which last year had part of its holdings in hyper-aggressive stock funds such as Van Wagoner Post Venture - at the end of this month; investors probably would be better served if the rest of that fund family, and all of its nonproprietary fund-of-fund competitors, disappeared, too.
For investors, the real issue becomes one of "Could I do this better on my own?" Even if you don't consider yourself knowledgeable about fund selection, there's a good chance the answer is "yes."
If you want the simplicity of a fund-of-funds, stick with the house versions.
Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.