Understanding funds of funds, wrap funds, multi-manager funds and linked products

The rapid growth of the South African CIS industry is a clear signal that collective investment portfolios are the favoured investment vehicle for the man on the street.

Benefits of investing in collective investment portfolios

• Collective investment portfolios are a very convenient and low-cost way of investing in markets which you otherwise would have found difficult to access.
• Average returns from CIS companies compare very favourably with returns from more traditional investment products.
• Collective investment portfolios are managed by highly qualified managers whose full-time job it is to make investment decisions.
• Collective investment portfolios are specifically designed to give you good value for money.
• The CIS industry in South Africa is strictly regulated by the Registrar of Collective Investment Schemes, ASISA and each CIS company's trustees.
• Collective investment portfolios provide diversification in a manageable way because each unit represents a pro rata share of an entire portfolio.

New investment tools

Many investors invest in more than one fund in order to achieve the diversity required to spread investment risk. To meet this need for diversification, packaged products have been designed, which allow investors to invest in a single product consisting of a number of collective investment portfolios or investment portfolios bundled together to suit particular risk/return profiles. Packaged products include funds of funds, wrap funds and linked products, all of which have collective investment portfolios as underlying investments.

The basic principle behind all these products is that the client/individual invests in a single product, which consists of a number of underlying funds managed by an array of fund managers. These products, often known as split investments, claim to offer greater flexibility than a single investment product, as investors are not locked into one investment from one company.

Fund of funds

A fund of funds is a collective investment portfolio fund that invests in a range of other collective investment portfolios. These could be funds within a collective investment portfolio management company's own range (internal fund of fund) or a selection of funds managed by various collective investment portfolio management companies (external fund of fund). A fund of funds may not invest in less than two underlying collective investment portfolios.

Ownership of units in a fund of funds

When an investor invests in a collective investment portfolio, the investor buys units of a fund which in turn uses the money to invest in assets which may include shares, bonds and cash. The investor owns the units or a portion of the collective investment portfolio relative to the number of units bought. However, when an investor purchases units in a fund of funds, the investor only owns the units in the fund of funds and not in the units of the underlying collective investment portfolios which make up the fund of funds. These units in the fund of funds are subject to the same legislation as the underlying funds.

Wrap Funds

A wrap fund is a portfolio consisting of a number of underlying investment tools wrapped into a single product. Wrap funds are not classified as funds of funds as the wrap fund itself is not a collective investment portfolio, but is in fact a portfolio of separate collective investment portfolios and money market accounts/instruments. The underlying combination of investment tools or instruments is selected to target the risk/return requirements of individual investors. The combination of the underlying instruments may be conservative, balanced or aggressive.

Ownership and management of units in a wrap fund

With a wrap fund the investor has direct ownership of the underlying investments. Wrap funds are not regulated by the Collective Investment Schemes Control Act and do not have separate legal status. They are controlled by the same legislation pertaining to Linked Investment Services Providers (LISPs), namely the Stock Exchanges Control Act and the Financial Markets Control Act. Wrap funds can be managed by almost anyone provided they are registered with the Financial Services Board (FSB) as a portfolio manager. Wrap Funds are offered by some Linked Product Companies and Asset Management Groups. Any registered portfolio manager can establish his own wrap fund and act as investment advisors for that fund. Investors are advised as to which of the wrap funds is suitable based on their risk profiles and investment needs.

Wrap funds can be administered by two types of LISPS:

1. Discretionary LISPs, where the administration and investment function of the wrap are housed within the LISP.
2. Non-discretionary LISPs, the administration is housed within the LISP and the investment function is outsourced.

Linked Investment Services Providers (LISPs)

A LISP is a company, offering a range of investments linked to collective investment portfolios and other underlying investments. LISPs are not product suppliers as such, but provide administrative systems to gain access to various suppliers of retail investment products including fund of funds, multi-manager funds and wrap funds. LISPs can link collective investment portfolio investments with other investment products such as retirement annuities and provident funds.

How does a LISP work?

LISPs develop investment packages comprising collective investment portfolios and other instruments in line with the investment needs of their client. They buy the units in bulk from collective investment portfolio companies, repackage them to provide investors with a choice of collective investment portfolios, and the opportunity to combine collective investment portfolios with other compulsory investment types such as retirement annuities or provident funds, or specialist plans. Buying in bulk allows LISPS to negotiate favourable initial charges and switching fees with the relevant Management Companies.

LISPs are regulated by Section 4 of the Stock Exchanges Control Act (1985) and Section 5 of the Financial Markets Control Act (1989).

Products offered by LISPs

Products offered by LISPs can divided into three broad categories:
Voluntary contributions: these are savings from after-tax income and are invested into growth/lifestyle funds or wrap funds.
Pre-retirement savings: these include retirement annuities, pension and provident funds and preservation funds.
Retirement products: these include living annuities and guaranteed income plans.
New Generation Life Products are similar to LISP products but offer a choice of investments through an insurance policy and are offered by life companies. They offer additional access to the insurer's in-house investment portfolios.

Multi-manager funds

Multi-manager is a method of managing a fund's assets. The multi-manager approach bundles asset managers together in different combinations to provide investors with choices designed to meet various risk profiles.

A multi-management collective investment portfolio invests in an actively managed blend of tailor-made specialist portfolios of equities and fixed interest instruments, by combining the investment styles of different fund managers into one investment product.

One fund is managed by numerous asset managers, each of them a specialist in a certain sector of the market, adopting different investment styles, favouring certain markets, trends or stocks. The choice of these external fund managers is a quantitative science, which involves the selection and blending of specialist portfolio managers who have been identified as being the "best of the best" in their particular investment style or approach.

How is a multi-manager fund managed?

The underlying portfolios are managed according to mandates set by the fund. To achieve the collective investment portfolio's risk and return objectives, fund managers are mixed using computer optimisation models to ascertain the extent of the exposure of each fund to each manager. As the market changes and as managers change their risk profiles by buying and selling stocks, the combination of managers in the fund is rebalanced using performance analysis to assess if the fund is on track.

The investor's tolerance to risk is assessed by striking a balance between the investor's expectation of return and his attitude towards risk. The multi-manager is then able to assess how aggressively or conservatively the investor's assets need to be managed, and thus which multi-manager best addresses the investor's requirements.

Some of the better known styles are:

Growth Style Managers

for example, are primarily interested in a company's earnings. Their bias is towards companies expected to exhibit profitability and shareholder earnings growth greater than their industry peers.

Value oriented Managers

Managers look for companies that they believe are worth more than the current value of their shares. They may purchase shares of companies that are currently out of favour with the market, believing that the shares are good value for the price based on future expectations of performance.

Market oriented Managers

Managers seek to develop well-diversified portfolios with average growth and valuation characteristics similar to the broad market. Many seek to add value by emphasising shares in economic sectors they believe have the most potential.

There are many more styles - for example, the strategic empowerment style, where managers focus on "black chips" and specific market sector styles.

Advantages of investing in funds of funds, wrap funds, mutli-manger funds and linked products:

Specific advantages

Disadvantages of investing in funds of funds, wrap funds, multi-manger funds and linked products:

Specific disadvantages