The Benefits of Fettered vs Unfettered Funds

12 June 2018

By Ronan Kearney, Verbatim Investment Committee Fund Structure and Governance

Fund of funds were developed as a useful and practical solution to running diversified portfolios. Offering many advantages in terms of Capital Gains Tax (CGT) efficiency and platform access, they grew rapidly in in the financial adviser market. Their rise was driven by the growth in multi-asset investing and a greater understanding of the benefits of diversification both of markets and investment styles.

A natural way to construct these funds in the early 2000’s was to select the best available managers in the market, and compose a portfolio of assets and styles. This offered a significant and obvious sales benefit for advisers, where they could provide their clients with a ready-made portfolio of the best managers.

One disadvantage from an operational point of view was that many of the better managers had restricted share classes, or were very expensive. Larger Fund of funds managers utilized their scale to secure rebates and discounts from the underlying managers, and this helped to some degree. However the advent of the Retail Distribution Review (RDR) made this strategy much harder to implement as rebates were made much more difficult to justify for specific investment groups, where they weren’t banned outright.

An additional disadvantage was the increasing costs of general fund administration, custody and trading. As regulated firms have been forced to hold increased amounts of regulatory capital, service fees have steadily increased to support the cost of holding this capital. As a result fund structures have experienced a steadily rising floor of regulatory and administration costs. Because Fund of funds are dual structure, i.e. one fund layer on top of another, this effect has been magnified.

Naturally Fund of fund providers were actively looking for ways to alleviate these costs, and many started to place an element of their assets into internal funds. In this way they could discount their asset management fees to some degree to reduce the overall costs.

A body of research throughout the 1900’s, including famous works by the likes of Eugene Fama, demonstrated that markets were efficient, and subsequent research demonstrated that it was virtually impossible to outperform a major market index over time. As a result many asset managers used main market tracker funds in order to gain exposure to key indices such as the S&P and the FTSE 100.

Another key development during this time was the rapid emergence of a new and efficient fund model, Exchange Traded Funds (ETFs). These offered ever improved tracking of key market indices, and have taken ever increasing amounts of assets under management as a result.

For many larger managers, where they produced their own in house tracker or ETF funds, it now made a lot of sense to utilize them on a reduced fee basis for key market returns. Some managers took that course of action to its logical conclusion and created portfolios comprised entirely of in-house efficient funds. Realistically this only a genuine option for fund managers with the required scale to manage cost efficient funds in multiple asset classes.

One obvious benefit of this move has been much reduced pricing at a headline level. In a post-RDR world advisers have welcomed ultra-low cost portfolios as a means of delivering greater value to their investors. But one element of market theory has been lost to some extent in this large move to in-house fettered portfolios, and that is the principle of diversification, that is, advisers and investors can easily find themselves with too great an exposure to one single counterparty. In the world of professional pension fund management, it is a generally recognized rule that no portfolio should have greater than 20% exposure to one counterparty or asset manager. In addition the regulation around UCITS funds has always restricted exposure to 20%.

However, as a result of a cost-driven move to in house portfolios, many clients may find themselves with exposure of up to 100% on their portfolios to one single asset manager. In an uncertain world, where even Banks the size of Lehman Brothers can fail, the costs of over-exposure may one day exceed the savings made.

In conclusion, both approaches offer benefits to investors. Unfettered portfolios offer greater diversification of underlying manager and investment style, whereas fettered portfolios typically offer lower prices, at the expense of diversification. For many advisers, keeping the 20% ‘rule of thumb’ is probably sensible when allocating a client’s investment. Combining portfolios to achieve diversification at a reasonable price may well prove to the correct long term decision.

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities.

Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use.