Are funds-of-funds the right play for client portfolios?

Single-ticket products offer convenience and easy diversification, but there are drawbacks, says alternative investments specialist

Are funds-of-funds the right play for client portfolios?

As advisors and clients alike look to expand their investing horizons, there’s been a steady increase in appetite for exposure to alternative investments. That’s ignited a rise in private market funds-of-funds – a trend that’s impressed one top portfolio manager.

“In general, the offerings are getting better and better, with new products coming into the market from big firms,” says Francis Sabourin, portfolio manager and investment advisor at Sabourin Wealth Management with Richardson Wealth. “After the market we had last year, we’re seeing more solutions to help advisors smooth out the volatility in their clients’ portfolios.”

Diversification - a double-edged sword

Sabourin is no newcomer to the world of alternative investing. For over 10 years, the portfolio manager has constructed his portfolios with a tricyle model of asset allocation that includes fixed income, equities and alternatives. That third wheel encompasses many strategies including private equity, secondary private equities, private debt, and private real estate.

For advisors looking to diversify beyond the traditional stock-bond portfolio, Sabourin says, there’s no question private market funds-of-funds should be part of the equation. One major factor to consider is the fact that they bring together exposure to a variety of strategies, and potentially different managers and regions as well. That diversification is a central factor to consider – although it’s not always a plus.

“Honestly, the more diversified you are, the better off you are in terms of risk, but not necessarily in terms of performance because you sometimes become overdiversified,” Sabourin says.

At his practice, Sabourin prefers to use high-conviction investments rather than single-ticket alternative solutions. For private real estate, he and his team prefer to buy focused exposure to a single asset class. He highlighted Alignvest Student Housing REIT, a specialist manager that concentrates on Canada’s purpose-built student accommodation (PBSA) space; the strategy is gated for new subscriptions but not for redemptions – a rarity for the private real estate investment space.

Similarly, Sabourin’s team doesn’t use funds-of-funds for private debt. Buying alternative funds directly, he says, allows them to dig deep and truly understand the strategies they’re exposed to, which is crucial to evaluate the underlying risks.

“Funds-of-funds make sense for smaller tickets. … A client might call and say they want to invest in private equity but could only give me a million dollars,” he says. “In that case, I might go with a fund-of-funds because it would help diversify their risks against potential bad outcomes.”

Funds-of-funds a good starting point

Compared to buying funds directly, he says buying funds-of-funds is easier, and may provide better liquidity. But they may also come with higher expenses, especially if the manager needs to create a new structure to make it work; those larger fees can be offset by the size of the fund, as some managers will have a schedule where fee rates get lower depending on the AUM in a certain fund-of-fund.

Sabourin underscored the importance of tax planning, as investing in a Canadian-domiciled fund-of-fund that invests in the U.S. or across the world can come with different tax implications. Advisors should also evaluate their level of knowledge about alternatives; generalists might be better off with a fund-of-funds, while specialists in the alternatives space might consider direct investments in alternatives as they can better understand the risk and performance impact those can have on a portfolio.

“As an advisor, you could start with a fund-of-funds,” he says. “Over time, as you get more comfortable with a specific asset class, you could start thinking about investing directly with one particular manager that you think has an edge over others.”

Teasing apart the individual strands of the alternative funds-of-funds trend, Sabourin says some managers are coming out with “sampler” funds that include several of their strategies, while others may run funds-of-funds that wrap their own strategies together with others from third-party providers. Large pension funds, he adds, are increasingly using single-ticket solutions to build more resilience and performance stability into their portfolios.

“A lot of products from the U.S. or Europe are coming to Canada, and they’re first-class products. But as an advisor, you have to understand the process behind them, and that takes time,” he says. “Ultimately, you need to be able to bring value to your clients in terms of asset allocation and portfolio performance.”