Do ETFs-Of-ETFs Make Sense?

May 11, 2011

Fund-of-fund ETFs get a bad reputation. But do they deserve the hate?

 

One of the lesser-discussed areas in the ETF universe is the “fund-of-funds” space. These are ETFs that hold only other ETFs. They come in a variety of flavors, but generally serve to broaden the already-diversified scope of most ETFs by investing in a mix of fixed-income, equity and—occasionally—commodities funds from around the globe.

Around the office, these funds get short shrift, and on the face of it, the naysayers are right. The argument I hear from my co-workers is that every ETF charges a fee, so an ETF that buys other ETFs just slaps another expense on top. Buying the individual ETFs would be cheaper, and nearly as easy.

But it’s not that simple.

These products aren’t aimed at financial wizards—these are funds that make owning a diversified portfolio a one-click process. They meet a clear need, as plenty of retail investors out there don’t have the time or expertise to look after a balanced portfolio alone.

But more importantly, the idea that these funds have to be overpriced is a myth.

Let’s say your risk appetite lines up nicely with the S&P Target Risk Aggressive Index. The benchmark tracks a basket of U.S. large-, mid- and small-cap equities with some emerging markets, TIPS and a bit of corporate bond exposure thrown in.

If a retail investor wants to allocate $10,000 to this strategy, he has to buy eight separate ETFs. At $10 a trade, that’s 80 basis points thrown away just getting into the position. Presumably, the investor wants to rebalance at least annually, so now we’re looking at 80 basis points a year just in trade commissions. And that’s before you take into account the fees of the ETFs.

The iShares S&P Aggressive Allocation Fund (NYSEArca: AOA) does all this at a cheaper rate. At just 55.81 basis points a year—including the fees of the underlying ETFs—AOA will get you the same exposure with just one commission at the outset, assuming the investor doesn’t have a commission-free account. As a bonus, the fund rebalances annually, free of charge. Sounds like a deal to me.

There are other funds-of-funds that cater to a variety of strategies. Target-date funds tailor their exposure over time toward a specific retirement date, gradually shifting toward more conservative investments as they near their target. Some of these funds hold equities and fixed-income securities directly, but the iShares’ S&P target date funds hold a series of—you guessed it—iShares ETFs that emphasize fixed income more heavily as investors approach the target date.

For example, the S&P Target Date 2030 Index Fund (NYSEArca: TZL) holds 19 percent in fixed income, while the S&P Target Date 2015 Index Fund (NYSEArca: TZE) allocates a more conservative 43 percent to fixed income. The rest of the weight of the funds is distributed to domestic and international equity, and a smidgen of U.S. real estate.

Even active management proponents have options. Plenty of actively managed ETFs use other ETFs as one of the tools at their disposal, but the recently launched Cambria Global Tactical ETF (NYSEArca: GTAA) from AdvisorShares blazes its own trail by being a true fund-of-funds and investing solely in other ETFs. The fund seeks absolute returns by investing in ETFs across asset classes.

Of course, the math of funds-of-funds only works out if your investment is relatively small. But that’s OK. At the end of the day, these funds aren’t aimed at people managing millions—they’re aimed at retail investors trying to figure out what to do with their 401(k). If the ETF space is good at anything, it’s providing products that suit a specific clientele at a reasonable price.

That’s exactly what the best of the funds-of-funds deliver, and that doesn’t sound so bad to me.

 

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