Exchange-traded funds (ETFs) are one of the most popular investment options. The number of ETFs trading globally has consistently increased in the last 15 years, from 276 in 2003 to 6,478 in 2018, according to Statista.com. With thousands of ETFs to choose from, how do investors choose? One way is by looking to ETFs of ETFs. These funds track other ETFs rather than underlying stocks, bonds or indices.
Like funds of funds, ETFs of ETFs provide investors with a method to invest in multiple strategies with one product. They combine the cost and transparency advantages of the traditional ETF structure with the research and analysis of an actively managed fund. Many well-established providers such as Vanguard have hopped on the bandwagon through new product offerings that combine different asset classes or rotate between sectors.
How do ETFs of ETFs work?
The concept of ETFs of ETFs finds its roots in traditional target-date and other asset-allocation funds that seek to provide simple investment solutions. An investment in a quality multi-strategy fund is appropriate for investors who still lack the skill or resources to construct an attractive portfolio in the current environment.
The ETFs-of-ETFs approach affords investors instant diversification, low fees and exposure to broad-based strategies across different asset classes. When a downturn occurs, a well-diversified portfolio employing various strategies can help keep losses to a minimum.
ETFs of ETFs are tools that provide more diversification than regular ETFs. They can be constructed on certain desirable factors such as risk levels, time horizons or sectors. One of these financial instruments can give an investor broad exposure to many sectors and asset classes.
On average, ETFs have lower fee structures, while managed funds tend to involve more research and analysis. ETFs of ETFs aim to strike a balance between the two and beat a standard benchmark index, according to Investopedia.
ETFs have an average expense ratio of 0.24%, while actively managed funds have an average expense ratio of 1.30%. The average expense ratio of ETFs of ETFs is somewhere in the middle of the two funds (0.68%), according to Morningstar.
How are ETFs of ETFs used?
There are three ways to use ETFs of ETFs:
Most ETFs disclose their holdings daily, so investors can piggyback on their best ideas without actually investing in them. For instance, by examining an ETF that has beaten the majority of its peers over the past year, investors will know which ETFs that ETF can consider the best, according to Money.
Some ETFs of ETFs expose investors to specific and timely strategies, while others are all-in-one portfolios of stock, bond and other ETFs that they can buy and hold. The latter ones tend to be the better deals. That is partly because they must compete with low-cost asset allocation funds and, therefore, must be cheap themselves. In addition, ETFs are a cost-effective way to gain exposure to broad asset classes.
As an example, Money cited a balanced ETF that invests in a mix of ETFs holding US stocks, foreign equities and bonds, and rebalances annually. That fund has beaten 60% of its peers for five years, charging just 0.25% in expenses.
ETFs of ETFs focusing on specific stock strategies have had a more difficult case to prove. As an example, Money cited an ETF that invests in five other in-house ETFs exhibiting the greatest momentum and reviews that portfolio every two weeks. However, this ETF’s 0.89% expense ratio, attempt at market timing and increasing size might cause investors to hold back. And when they have just five holdings in a $2.5 billion fund, selling one holding can cause a big jolt to that underlying ETF.
All-in-one ETFs of ETFs may also invest in only half-a-dozen or so funds. However, those asset allocation ETFs do not make adjustments weekly. Moreover, getting the asset allocation right can matter a lot more than selecting the individual securities. “And if funds can do it cheaply, all the better,” said Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA.
What are the limitations of ETFs of ETFs?
Although many of the newest ETFs of ETFs claim to simplify investing, they often use complex mechanisms that make it hard to understand the various offerings in those funds. Moreover, the products are often highly concentrated and tend to demonstrate higher turnover than most actively managed funds. When the market turns against them, they could quickly become the largest holder of thinly traded ETFs.
A more straightforward (and cheaper) approach involves constructing a portfolio of individual stock and bond ETFs. In addition, investors must rely on the skill of the portfolio manager to make critical asset allocation and adjust the portfolio tactically and timely. Most empirical research finds a hands-off, buy-and-hold approach tends to outperform a stock-picking strategy, according to Investopedia.