Credit: Shutterstock photoMost investors associate exchange-traded funds (ETFs) with the benefits of diversification, liquidity, low costs, and transparency. These factors make them extremely attractive to both short-term traders and long-term investors alike. There is also a subset of ETFs called “fund of funds” that take diversification to the next level and may require deeper analysis to assess the value proposition they suggest.
These baskets incorporate a group of underlying ETFs or closed-end funds as their primary investment allocation rather than direct exposure to traditional stocks or bonds. The benefit is that one of these vehicles can potentially own just 8-12 underlying funds and invest in a large swath of the global marketplace. However, this structure can also impose an additional layer of fees and potentially obscure exactly what the shareholder owns.
Let’s look at a few examples to better understand the pros and cons of this category. The largest ETF in this class is the First Trust Multi-Asset Diversified Income Index Fund (MDIV). MDIV is broken up into 20% allocations to REITs, dividend paying stocks, preferred stocks, high yield bonds, and master limited partnerships. The index contains 125 underlying securities and assets are rebalanced on a quarterly basis.
This ETF charges a net expense ratio of 0.68%, has a 30-day SEC yield of 6.35%, and total assets of $873 million. Clearly this investment style will resonate with aggressive yield-seekers who desire a single position with high current income, automatic rebalancing, and a broad spectrum of asset classes.
Nevertheless, it’s worth pointing out that the MDIV portfolio can likely be duplicated with a mix of five ETFs to represent the underlying asset classes. This may potentially lower your annual investment expenses and allow for greater flexibility of position sizing within each sleeve of the strategy. Of course, you will have to do the rebalancing on your own, which may boost the value proposition of the one-stop ETF in many investors’ minds.
Another popular fund in this space is the iShares Core Growth Allocation ETF (AOR). This ETF implements the popular 60/40 allocation to stocks and bonds in a diversified vehicle. It accomplishes this by owning a group of 10 underlying iShares ETFs with both foreign and domestic exposure. AOR charges an expense ratio of 0.22% per year (net of the expenses from the underlying holdings) and has $764 million under management.
A fund of this nature will appeal to conventional investors who want a low-cost core holding with a broad mix of stocks and bonds. It may also be attractive for smaller accounts that want to minimize the use of multiple positions to reduce trading fees and other expenses.
It’s worth pointing out that even though AOR owns just 10 underlying holdings, the trickle-down effect of the index construction means that you actually own thousands of securities around the world. To understand those intricacies, potential investors must research the position size and underlying holdings for each ETF in the portfolio. That information is available via the fund provider’s website.
Lastly, there are also ETFs that track closed-end funds as well. These are perhaps the most expensive and most opaque of the bunch. However, they also offer access to differentiated investment styles and deliver high yields through the use of leverage in the underlying components.
The PowerShares CEF Income Composite Portfolio (PCEF) and YieldShares High Income ETF (YYY) are two examples of these closed-end fund indexes. Closed-end funds offer their own unique risk dynamics and utilizing these vehicles may offer a simple way to access a diversified basket rather than choosing individual positions. Nevertheless, both ETFs charge a management fee of 0.50% on top of the pass through expenses of the underlying funds. Those typically range between 1.30%-1.50% on average.
The Bottom Line
There are both pros and cons to this type of asset allocation ETF style that should be carefully considered before you decide to invest. Ask yourself the following questions:
- Does this ETF offer a reasonable management fee for achieving its stated objective?
- Do I clearly understand the investment style, risks, and underlying portfolio asset allocation?
- Would I be better off implementing a similar strategy using multiple funds and skipping the “fund of funds” overlap?
- Does this strategy provide enough flexibility to meet my needs?
- Is there a unique aspect to the “fund of fund” portfolio that I can’t readily access elsewhere?
If the answers to these questions line up with your investment thesis, then you are more likely to experience a successful outcome using these tools.
Disclosure: At the time this article was written, the author and some clients of FMD Capital Management owned shares of AOR.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
