Much is written these days on manager of managers funds but it would not be surprising if many potential investors are not entirely clear about the difference between manager of managers funds and funds of funds. Basically, it seems to me that it is all about the structure.
Under a fund of funds, the fund in which the client invests and receives shares or units itself invests in other retail funds. Sometimes these are funds of the lead fund provider (often known as fettered funds) and sometimes funds of other providers (unfettered funds).
Under most manager of managers funds, the lead fund manager does not invest in other retail funds but instead (rather like pension fund trustees appointing investment managers) grants a mandate to other fund managers to manage a proportion of the lead fund's money.
Under both models, there is clearly an extra layer of charges and, especially when returns are harder to come by, charges are not insignificant factors. In comparing the two models, net-of-charge performance is the key determinant.
Basically, it will be necessary to run a clear cost/benefit analysis to determine the value for money that is secured for the investor.
From a tax standpoint, the fund of funds and manager of managers structures are identical. Income produced by the underlying investments will be assessed on the investor whether paid out or reinvested. There will be a 10 per cent tax credit for dividends which will cover any basic-rate liability for the investor.
This will mean that basic-rate taxpayers will pay no further tax and higher-rate taxpayers will have a 32.5 per cent liability on the grossed-up dividend and can then deduct the 10 per cent tax credit in determining the tax that is actually payable.
Sadly, non-taxpayers still cannot make any tax reclaim.
All switches between funds, sub-funds and managers by the lead fund manager will not constitute a chargeable disposal by the investor and no capital gains tax will be due from the investor or the fund.
The only time a liability will arise is when the investor disposes of his investment in the units or shares in the lead fund. However, the outer shell must strictly be a separate legal entity inside which the underlying funds exist as assets legally owned by the outer shell or lead fund manager. Where an investor himself invests in different shares or sub-funds of an Oeic, then switching between such shares or sub-funds (which are not held inside a separate outer shell) will be disposals by the investor for capital gains tax purposes.
An important tax feature for both the fund of funds and the manager of managers structures is the protection from capital gains tax and the ability to accrue a valuable ownership period for taper relief. With up to 40 per cent of gains being tax-free after 10 years by virtue of taper relief, and with taper relief applying before the annual exemption, this feature can be extremely valuable.
This is important, bearing in mind that, according to Inland Revenue statistics, most investments are disposed of within two years, with just 12 per cent of disposals being after 10 years.
Of course, there are many possible reasons why this picture emerges. One of the reasons may be that comparatively few investors are aware of the benefits of taper relief or the benefits offered by investing through a distinct legal outer shell such as a fund of funds or manager of managers fund (with the resulting tax protection).
Alternatively, it may be that investors are aware of this but prefer to hold investments directly, retaining the right to switch themselves rather than ceding that right to a lead fund manager.
Whatever the reasons driving the high rate of disposals highlighted by the Inland Revenue statistics, it may well pay the adviser or the investment fund manager to at least communicate the tax benefits of the fund of funds or manager of managers fund structures for long-term investment to a wider community of potential investors.
It is often the case that too little thought is given to the various tax planning qualities of collective investments, with too much concentration on performance. This is not to say that tax planning is more important than securing good performance – obviously, without performance, there is nothing to tax plan with, save for managing the effective use of losses – just that bottom-line performance can often be substantially improved with tax planning.
There is also the not inconsiderable point that, on the death of an investor in a collective investment (as is the case for an investor in direct equities), regardless of whether the structure is a fund of funds or manager of managers fund, all capital gains accrued to date are wiped out. The inheritors inherit with a fresh base value for future capital gains tax purposes.