This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Ron Rowland, a portfolio manager with Bloomfield Hills, Michigan-based Flexible Plan Investments. He lives in the Atlanta metropolitan area.
The fund-of-funds ETF structure provides an efficient and economical approach to the implementation of many investment strategies. Although critics often complain that fund-of-funds ETFs only put fees on top of fees, the reality is often quite different, making the structure a welcome addition to the investment world.
Typically, an ETF directly owns the securities in the index it is tracking. For example, the SPDR S&P 500 ETF (SPY) owns all 500 stocks in the index. When the index adds or removes a stock, the ETF does the same thing.
However, a fund-of-funds ETF owns other ETFs instead of own the underlying stocks, bonds or other securities directly. Why do they do this? For the same reason you buy ETFs: It is much more efficient and cost-effective to buy a single S&P 500 ETF than it is to buy all 500 stocks in the S&P 500 in their proper allocations and to manage all the index changes.
The chart below illustrates the concept. In this example, ETF “A” is a fund-of-funds ETF that has only three holdings. Each of those holdings is a traditional ETF that directly owns the underlying securities.
Let’s assume ETF “A” is pursuing a traditional 60/40 asset allocation strategy of having 60% invested in stocks and 40% invested in bonds. It also makes the further allocation of having two-thirds of its stocks in U.S. companies and one-third in foreign equities.
For its 40% U.S. stock exposure, ETF “A” could buy the Vanguard Total Stock Market ETF (VTI), or it could buy the 3,578 stocks that VTI owns. For its 20% foreign equity allocation, ETF “A” could buy the Vanguard Total International Stock ETF (VXUS), or it could buy the 6,060 securities that VXUS owns. For its 40% bond allocation, ETF “A” could buy the iShares Core U.S. Aggregate Bond ETF (AGG), or it could buy the 6,086 bonds and securities that AGG holds.