The risk of not knowing what’s inside of a fund investment is one which has shown a very consistent history for causing problems. From money-market funds and guaranteed deposit investments to mutual funds, not knowing the contents of an investment fund has proven to be disastrous, particularly over the last 10 years.
As such, we need to have a way available to fill in the gaps that an investment adviser leaves us with when we are evaluating an investment decision. Specifically, when we are stuck with a summary of a mutual fund position that is highly recommended, but composed of nothing but other mutual funds, we need to know how to follow up with our own research to understand exactly what’s going on behind the curtain.
The first step to digging into a fund-of-funds position is to look at what the individual investments are in the company, and to determine what class of investment they are. Are these the same ‘investor’ class funds that are available to any individual on their own for a reasonable investment amount, or are they ‘ adviser’ or ‘institutional’ class shares that require large initial investment amounts.
More often than not, a fund-of-funds will contain institutional class fund units, because they allow the advising company to take advantage of the scaling of the larger shares, and then pass on some savings to their customers. It is therefore very important for us to understand this aspect of the held funds, because the difference is enough to impact our investment decision (why pay an advisory fee for a mutual fund that we can buy on our own? We want to focus in on the institutional-scale that creates savings for our portfolios).
Upon determining the type of position that’s held in our potential investment, we can then start to investigate the actual holdings of the position by searching out institutional fund through a tool like Morningstar or yahoo finance. These tools will allow us to look at a very detailed summary of the fund itself, and also provide links to the actual fund prospectus for those nosy investors that want the most specific details.
The information that we are most interested in from these summaries is the holdings data. Specifically, we want to catalog the weightings of specific positions inside the held fund. We will do this for every single position that is within the fund of funds, which means that we’ll probably wind up with a very extensive list of securities that are being held throughout the entire position.
The final step in examining a fund of funds (at least in this particular situation) is to investigate the individual holdings for duplicate positions, and for over-weighted positions. For example, a blue-chip mutual fund that holds multiple fund-portfolios of blue-chip stocks will likely have overlap between its holdings. The risk here is that the purchased mutual fund will wind up over-exposed to a specific blue chip position, to the point at which the fund is unbalanced.
Realistically, why would an investor want to purchase a mutual fund that is overlapping to the point at which it is really only exposed to 10 stocks, when they can simply buy those 10 positions on their own and not pay the mutual fund fee? The end result is that we will have an understanding of the full exposure of the investment opportunity, and will be able to make a fully educated decision about how it is that it fits within our existing portfolio.