One-stop-shop ETFs offer certain advantages, but investors should also keep some things in mind
Aside from transparency, liquidity, and low cost, one important thing that ETFs promise investors is easy diversification. And now more than ever, investors have an opportunity to get that through the increased availability of ETF funds-of-funds.
“Funds of funds have a long history in the mutual-fund industry, and are now taking root in the ETF world,” noted the Wall Street Journal. Citing data from Morningstar Direct, it said that there were 99 ETF funds-of-funds registered in the US, up from 48 at the end of 2014.
Broadly, fund-of-fund ETFs can be grouped into two categories. Speaking to the Journal, Todd Rosenbluth, CFRA’s head of ETF and mutual-fund research, explained that asset-allocation ETFs are essentially model portfolios that hold stocks and bonds in an ETF wrapper.
The other group consists of sector- or theme-focused products, which can be systematically rebalanced or switched depending on which subsectors are experiencing the highest sales growth. “[T]hematic ETFs require confidence in the long-term horizon of these themes, but the short-term performance can be bumpy,” Rosenbluth said, explaining the benefit of enhanced diversification within a sector.
Fund-of-fund ETFs can be a lifesaver for investors who don’t want to spend time and mental energy keeping their portfolios on an even keel. But as noted by Morningstar Director of Global ETF Research Ben Johnson, investors working with advisors may end up paying more money than they’re comfortable with to purchase one such ETF.
The costs of ETF funds-of-funds can be contained if they’re built using ETFs from the same fund family, though that could also limit investors’ returns as there’s a low likelihood of all members of the same family being top performers. Multi-fund ETFs that incorporate funds from different families, on the other hand, typically come with an overlay fee on top of what each component charges.
Johnson also spotlighted the importance of making sure a fund-of-fund ETF has a thoughtful, coherent overarching objective directing its underlying methodology. “A target-date series or an allocation portfolio would be examples of funds-of-funds that fit this mold; a potpourri of disparate thematic funds would not,” he said.
Another possible pitfall for funds of funds comes from their greater potential for taxable capital gains. While index ETFs are regarded as tax-efficient for buy-and-hold investors as indexes don’t frequently change their holdings, a fund-of-fund ETF that has to rebalance monthly to maintain a target weighting can incur more taxable capital gains if its component holdings are volatile.
“Just like any other commingled vehicle with a high turnover strategy, there are more opportunities for a taxable event in the fund, versus a similar strategy with lower turnover,” said Noel Archard, global head of SPDR products at State Street Global Advisors.
