While external funds of funds (FoFs) have grown faster than internal FoFs in recent years, a new breed of low-cost passive in-house fund holding ETFs is likely to prosper, according to a study by research house Cerulli.

Cerulli cites in-house funds of ETFs offered by the likes of Deutsche Bank and Vanguard as likely to perform strongly.

The firm found that external fund of funds (FoFs) – those composed of funds created outside the firm – have been growing faster than internal FoFs in recent years.

External FoFs offer enhanced risk diversification compared to internal FoFs – a valuable trait to investors – and may see further inflows providing asset managers can convince investors that the additional layer of cost can be contained and is justified by results.

Nonetheless, in a low-return envrionment, costs remain a key concern.

Angelos Gousios, director, European retail research, Cerulli, explains: “Investors usually have to pay two layers of fees. One is to the manager picking the funds. This manager, in turn, has to pay to buy into the underlying funds, even in the case of a fettered fund, where the transfer of money is internal.”

Cerulli says that for most FoFs, the effect of the extra layer of costs is clear. An equity FoF may have an annual management charge of around 137 basis points (bps) but the ongoing charges paid by the investors could be as high as 230 bps, a difference of 68%.

This compares to a standard equity fund which is likely to have a management charge of around 129 bps and an ongoing charge of around 167 bps, a difference of only 28%. Funds of funds incur extra costs, according to Cerulli, for the simple reason that investing in other funds will tend to push the total cost up more than, say, the trading costs of buying shares.

However, with investors increasingly focused on costs, a new breed of low-cost passive internal FoFs, including those built using ETFs, is gaining in popularity.

Gousios added: “It is extra expense that investors want justified. If costs are paramount, a fund of in-house passive funds is one obvious solution. In the age of ETFs, a fund of ETFs is only logical.” Gousios cites the type of funds offered by Deutsche Asset Management and Vanguard as examples.

Vanguard’s proposed ETF of ETFs, the Vanguard Total Corporate Bond ETF, will invest directly in three existing, low-cost ETFs (the Vanguard Short-Term Corporate Bond ETF (VCSH), the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), and the Vanguard Long-Term Corporate Bond ETF (VCLT)) and charge fees of just 7 bps per annum.