Funds of funds are a breed of unit trust. Instead of investing in shares or bonds directly, they hold units of other unit trusts. The idea is that by buying units of a fund of funds, you spread your risk much more widely than most unit trusts can. Through this collection of collective funds, you could divide your money between 20 times more stocks and bonds than in a single unit trust.
Many fund management groups, such as Gartmore and M&G, run at least one fund of funds alongside their more directly invested unit trusts. Some buy from any unit trust available, while others stick to the group's own unit trusts. One drawback of in-house funds of funds is that the fund managers have far less choice. They could end up having to invest in unit trusts with mediocre performance prospects just to get the maximum diversification.
Some funds of funds invest broadly across all types of unit trust, while others are confined to one sector - emerging markets, for example.
Two companies manage nothing but funds of funds - Pilgrim Unit Trust Management and Portfolio Fund Management. Each firm manages six funds, with most of them specialised rather than being broader-based.
Portfolio was set up as a public operation in 1994, beginning by taking one fund public, the Portfolio Fund of Funds, which had been a private fund since 1989. It now has around pounds 70m under management. Out of 31 funds in the broad funds of funds sector over the past five years it has been the star performer, according to MoneyFacts, the financial information provider. A pounds 1,000 investment five years ago would have ballooned to pounds 2,099.19. But over the past year, comparative performance has waned to place the fund 37th out of 81.
"We're giving to the small investor the possibilities that only big investors usually have," says Tim Miller, chief executive of Portfolio and former marketing guru of M&G. If you invested directly in shares, you would need huge sums to get a really high level of diversification.
For people buying PEPs, funds of funds were the sixth most popular type of fund in April, according to the Association of Unit Trusts and Investment Funds. Over pounds 111m of units in funds of funds were sold in the month.
One problem, however, is that fees can be higher than with other types of unit trusts because of possible double-charging. If the fund manager has to pay all the fees due to each unit trust it invests in, these soon mount up.
However, Mr Miller says Portfolio is able to keep this snag to a minimum by economies of scale. "We very rarely have to pay initial charges and we get rebates on annual charges." Nevertheless, you can expect to pay on average an extra 1 per cent in charges.
Funds of funds theoretically escape the worst falls other unit trusts suffer, but of course you pay for this safety net by missing out on spectacular gains.
"Performance is not sparkling by any stretch," says Bryan Fisher, independent financial adviser at Berkeley Financial Planning in Coventry.
In the sector, Berkeley has recommended the Britannia Managed Portfolio, which has produced an annual rate of return of 15.7 per cent over the past five years. The Morgan Grenfell Managed Income fund has also been recommended, and has yielded 14.9 per cent over the same period, he says.
Mr Fisher says that personally he is not a fan of funds of funds, although he accepts that they are suitable in certain circumstances. "If you're building up a portfolio, you might put some money into them to create a balance.
"But it's much easier to spread your money around a bit among the unit trusts ... to create a portfolio of the better unit trusts, rather than putting it into a fund of funds, and accept the higher charges," Mr Fisher says.
However, for big investors there is a tax advantage. Each time you switch your money from one unit trust to another you have to pay capital gains tax. But transactions within one unit trust are free of this tax.
Funds of funds with their safety-first image are often seen as ideal first-time investments. But Mr Miller says demand comes from the very wealthy. "As people become richer, it becomes more important for them to preserve what they have ... the richer you are, the more cautious you are."
Useful phone numbers
Pilgrim Unit Trust Management 0191-201 3927
Portfolio Fund Management 0171-638 0808
Berkeley Financial Planning 01203 555240
Morgan Grenfell Asset Management 0171-545 6000
Britannia Life 0141-248 2000
M&G Group 01245 390390
Gartmore Investment Management 0171-623 1212