A change in securities law might lead to a boom in funds of funds, mutual funds that invest in the shares of other funds.
Market observers say the change is just in time to serve the growing appetite of defined contribution plans and individual investors for a managed product that relies on a professional money manager or registered investment adviser to make the allocation of assets according to investment objectives and risk tolerances.
The companies most likely to benefit from the SEC changes are large multiproduct firms that will be able to construct complete portfolios from their own mutual fund stables. Plan sponsors are more likely to favor mutual fund companies that use an established investment management approach to building funds of funds, said Cebra Graves, a Morningstar equity analyst.
The National Securities Markets Improvement Act of 1996 "will have a huge effect for a variety of reasons, but most importantly for defined contribution plans," said Geoffrey H. Bobroff, president of Bobroff Consulting Inc., East Greenwich, Conn.
"It has a fascinating application in the ability of broad-based, multiline money managers with lots of fund styles to come up with a very focused response to the needs of a defined contribution plan sponsor. Focusing on specific risk requirements of a client, a manager could create a very style conscious and risk-adjusted fund of funds that meets the sponsor's needs exactly. Managers can design both a generic fund-of-funds product for mass market appeal and yet retain the ability to customize for individual clients. It's an area yet to be exploited."
The main losers could be brokers and consultants offering mutual fund wrap programs, primarily for retail investors, said several observers.
Said Peter Starr, a consultant at Cerulli Associates Inc., Boston: "Funds of funds will certainly cause some cannibalization of wrap programs and will at least force the competition to show costs of the wrapper fairly.
"Large investors will want the customization of the portfolio their broker puts together for them," Mr. Starr said. "But smaller investors may be content with the fairly generic asset allocation models possible with a fund-of-funds approach."
Existing funds of funds vary in fee structure. Many companies using all in-house funds only levy the mutual funds' expense ratios, and no advisory fee. Some also use institutional share classes of underlying funds to bring down the costs for institutional shareholders.
The National Securities Markets Improvement Act, signed Oct. 11, relaxed the onerous filing and management requirements for funds of funds. Mutual fund companies no longer will have to apply for Securities and Exchange Commission regulatory exemptions - which had taken as long as two years - if the proposed fund of funds and the mutual funds in which it invests are all from the same investment management company.
According to Morningstar Inc., Chicago, and other sources, only about 60 such funds of funds have been established. Mutual fund consultant Strategic Insight, New York, estimated in a study of lifestyle funds that the universe of 80 asset allocation portfolios, of which funds of funds is a part, only held about $32 billion as of July 31.
The oldest funds, the Vanguard Star Portfolio and the T. Rowe Price Spectrum funds, were first granted SEC exemptions to invest in affiliated mutual funds in 1985.
With the relaxation in SEC regulations, mutual fund managers now have more options for structuring asset allocation funds, such as lifestyle funds.
"The most apparent result of the SEC's relaxation on funds of funds is the effect on the cost structure of these kinds of funds," Cerulli's Mr. Starr said.
"Under the old system, the small upper limits on investment in a single mutual fund meant that managers had to spread out their assets among many funds. It is very expensive to invest in a lot of funds, because the client has to pay both the expense ratios for each of the many funds, as well as a wrap to the asset allocator. The new system allows a manager to invest more in fewer funds, which is more cost effective and user friendly."
Dan Gross, a principal at Scudder, Stevens & Clark Inc., Boston, which offers a new series of funds of funds, said the concept is more efficient because it gives a mutual fund manager the ability to invest a small amount of money in a larger pool.
"Investing in a fund of funds is much easier than attempting to replicate the style and performance of a large mutual fund. It's very expensive to handle all the transactions necessary to trade all these individual securities in smaller portfolios," he said.
Mr. Gross added Scudder's market research showed many retail and institutional investors prefer to invest in a fund of funds because each asset class used had a published track record that was easy to follow.
But the model the new law codifies - funds of funds composed of affiliated funds - already might be somewhat outdated, said Ken Berman, assistant director of the SEC's division of investment management.
"The (new) law contains .*.*. provisions designed to codify a series of exemptions granted by the SEC in the past to funds of funds using affiliated funds. But the law does codify a model that was popular two years ago, not necessarily the model the market wants today," said Mr. Berman.
The latest model centers around direct investment in domestic equities and bonds, with investment in other mutual funds for certain asset classes - international equity, real estate and emerging markets.
"I think people looked at the new legislative order and realized they couldn't necessarily get what they wanted from it. We have seen a steady, constant flow of applications for exemption for this new kind of model," said Elizabeth Osterman, assistant director of the investment management division's office of investment company regulation at the SEC.
The SEC also will review applications for exemption from the limits placed on how much can be invested in funds with outside fund families, said Mr. Berman. "The legislation makes it clear that the SEC is waiting for well-thought-out exemptions to review, with an eye to perhaps updating the model later," he said.