Take a Closer Look at Fund of Funds

Physician's Money DigestOctober 2005
Volume 12
Issue 14

Despite high expenses,some physician-investorsare still drawn toopportunities offeredby fund of funds: diversification,professional fund selection,monitoring, and built-in asset allocation,all conveniently bundled intoone mutual fund. There are two basictypes of fund of funds: sector fundsand asset allocation funds.

Sector funds offer growth byinvesting solely in businesses within aparticular industry or sector. Thesefunds increase in price when there isdemand for the service or product,and decrease when there is not. Assuch, some fund managers rotate sectorfunds in and out of portfolios asthey see fit, avoiding sector funds indecline while participating fully insector funds on the rise.

However, sector funds assume thatthe fund manager can predict whichsectors and funds will benefit duringeach phase. To believe that a fund managercan determine which sector fundswill perform well requires a leap offaith unsupported by any mutual fundperformance figures.

Asset allocation or life-cycle fundsare another type of fund of funds,which allow for diversification andminimize risk by investing in severaldifferent asset classes at the same time.By varying the proportion of stocks tobonds, the fund attempts to provide anappropriate asset allocation for physician-investors in different stages oftheir lives. For example, life-cycle fundscan hold one or more stock funds alongwith bond funds.

Before you invest in a fund of funds,physician-investors should considerthe following issues:

1) Asset allocation might not beoptimal. The mixture of stocks tobonds might not exactly match yourinvestment needs or you prefer a differentmix. For example, you mayprefer large cap mutual funds to smallcap. It's also possible that you wantbonds of a different duration thanoffered by the fund of funds.

2) Business decisions of thesponsor can affect fund selection.At some brokerage houses, funds sharemanagement fees or pay distributionfees in order to participate in the sponsor'splan. This arrangement creates aclear conflict of interest, leading directlyto fund choices with higher-than-averagefees. Choices might also berestricted to funds offered only by thesponsoring mutual fund company.

3) Subsequent reallocation anddistribution planning is more difficult.If you need to withdraw money,you'd have to sell shares that hold bothstocks and bonds, regardless of the performanceof each. This could require liquidatingequities at the bottom of a marketcycle, even though you might preferthem to recover. Additionally, if youwant to increase your percentage ofbonds, you may have to sell many sharesof your life-cycle fund to accomplish thisreallocation, resulting in substantiallyhigher tax and transaction costs.

4) Managing taxes is difficult. Byselling an individual mutual fund atthe end of the year, you can avoid adistribution or generate a tax loss, ofwhich you may wish to offset sometaxable gains. This opportunity isn'tavailable with a fund of funds.

Keep in mind that not every fund offunds will have all of the issues listedabove. Each physician-investor shouldindependently determine their individualasset allocation plan and fund selectionprocess. Although this processmight take some time and effort onyour part, designing and tailoring yourinvestment plan to meet your individualobjectives and situation should paybig dividends.

Frank Armstrong III is the author of The

Informed Investor: A Hype-Free Guide to

Constructing a Sound Financial Portfolio

(Amacom; 2003). He has built up a solid following

for his personal finance advice on

talk radio and other business media, including CNNfn. For

more information, visit www.investorsolutions.com.

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