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Funds Of Mutual Funds May Soon Be More Fetching

Personal Business: INVESTING


At first blush, mutual funds that invest in mutual funds seem like a good idea. Rather than sorting through 7,000 options on your own, a fund of funds does the work for you, putting the choices together in a single portfolio. The investor gets less volatility, a broader exposure to manager expertise, and more diversification than one fund could offer.

The problem? The equity multifund funds that buy shares from several different families have been plagued by high expenses, which erode returns. "The investor is paying twice: once for management expenses of each underlying fund and again for someone to manage the portfolio," says Gerald Perritt, editor of Mutual Fund Letter in Chicago.

DIRECT HIT. But two industry developments could lead to lower costs and better net returns. First, Charles Schwab & Co. is staging a direct hit against the high-cost funds by launching three new multifund funds with expense ratios of just 0.5%. The average fund of funds charges 1.40% of assets. Second, Congress is expected to pass a bill by the end of October that would loosen regulatory restrictions on such funds, leading to more competition and lower prices.

Until now, the lowest-cost funds of funds have been those operated by a mutual-fund company rather than a money manager. The company simply buys shares within its own family of funds at no extra charge, and the investor pays only the expenses of the underlying funds. T. Rowe Price and Vanguard Group are the only two mutual-fund companies that offer such low-cost proprietary funds of funds.

T. Rowe Price Spectrum Growth, which has no fee on top of the 0.83% that is charged by the underlying funds, posted a one-year return of 17.88% through Aug. 31, 1996. Compare that with Maxus Laureate, a fund that counts Heartland Value and Mutual Shares Discovery among its holdings. After subtracting the steep expense ratio of 3.85%, Maxus Laureate's one-year return amounted to just 13.05%, more than a point below the average of 14.32% for U.S. diversified equity funds. (Bond funds of funds don't suffer from excessive fees, but there are only nine of them vs. 39 in the equity category.) "There is no reason to charge 1% to 2%" or more for the management of these funds, says Bill Klipp, president of Charles Schwab Investment Management. "Price competition will bring some sanity" to the multifund funds. Schwab may not be the only company bringing more competition. Multifamily fund managers have been bound by a Securities & Exchange Commission rule that prohibited them from buying more than 3% of the shares of any one fund. That's why many funds of funds have 20 to 40 picks in their portfolios. The bill in Congress would allow managers to petition the SEC to buy a greater piece of any fund. Bigger stakes would mean fund managers wouldn't have to pay fees on as many underlying funds. That would make the umbrella funds cheaper and easier to manage.

Even single-family funds will be easier to establish. T. Rowe Price and Vanguard have had to overcome significant regulatory hurdles, and other fund companies haven't been as successful.

For instance, when a single-family fund of funds wanted to purchase more than 15% of any underlying fund, it had to petition the SEC. "The bill would permit broad regulatory relief to companies that want to start a [proprietary] fund of funds," says Robert Plaze, associate director of the SEC's investment management unit.

Despite the high fees, multifamily funds of funds have some benefits even now. Because the managers typically buy more than $1 million in shares of a fund, companies waive the loads that an individual investor would have to pay. Such funds also can provide an opportunity to get into a closed fund. For instance, the largest holding of Flex-funds Muirfield is T. Rowe Price New Horizons, a small-cap growth fund closed to new investors.

Overall, funds of funds are useful for people who have limited assets to spread around or don't want to research fund picks. "It's good for those who would have been uncomfortable taking the risk of investing on their own," especially in a single, volatile small-cap fund, says Peter Van Dyke, manager for T. Rowe Price Spectrum funds. What's more, they get access to funds with minimum-purchase requirements that they could not otherwise meet.

Those with $100,000 or more, but little inclination to shop around, should bypass the prepackaged funds of funds and consider a fee-only financial planner or a mutual-fund wrap account with a personalized portfolio of funds.

Fees have recently come down and generally range from 0.75% to 1.5% of assets under management. Funds of funds do have their advantages for the right type of investor. The benefits are only likely to grow as the choices proliferate, costs come down, and returns improve.EDITED BY AMY DUNKIN By Toddi GutnerReturn to top

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