'Funds of funds' offer simplicity, diversity

Diversify your diversification.

Sounds mind-boggling, but that is the goal of "funds of funds." These are mutual funds that invest in shares of other mutual funds.

Such an all-in-one fund makes investing simple and is considered well-suited to beginning investors who don't have a lot of money to spread around. They achieve diversification and reduce volatility through one package of several different funds.

These usually include an assortment of stock and bond funds using a variety of managers and styles.

The folks who might frown on such a arrangement are those who don't consider themselves "average" at all and think they could do better by handling their own asset allocation.

"Funds of funds are for people who want to spread a small amount of money among several investment products," said Mark Salzinger, publisher and editor of The No-Load Fund Investor (www.noloadfundinvestor.com)in Brentwood, Tenn. "They prefer not to follow their investments as much."

The granddaddy of these funds of funds and a Salzinger favorite is the $13.7 billion Vanguard Star Fund (VGSTX), launched back in 1985. It invests in 11 Vanguard funds, keeping a stable asset allocation of 62 percent stocks, 25 percent intermediate- and long-term bonds and 13 percent short-term bonds. It uses six domestic stock funds, two foreign stock funds and three bond funds to accomplish this.

Star, down 4 percent this year, has a three-year annualized return of 8 percent and five-year annualized return of 11 percent. It features a low minimum initial investment of $1,000.

Its annual expense ratio is a low 0.32 percent. Vanguard and a number of other "no-load" (no sales charge) fund families don't tack on a second expense ratio to pay for bundling the funds.

Some other funds of funds have two expense ratios, one for the underlying funds and another for repackaging in the proper allocation. This is particularly true of those that invest in funds outside the fund family. That's why, since the beginning of 2007, funds of funds have been required to provide a breakout of direct and indirect expense ratios in their annual reports.