Do Funds of ETFs and "Lifecycle Funds" make sense?

John Spence reports that MetLife has filed a registration statement for two mutual funds that will invest exclusively in ETFs. He notes that the expenses of these funds, which are layered on top of the expenses of the underlying ETFs, raise the costs investors will pay. And he notes that two earlier "funds of ETFs" performed poorly. Does that means that funds of ETFs are unattractive? Not necessarily. Here's why:

A key attraction of ETFs is that they simplify portfolio management. Investors no longer need to research and track tens of individual stocks, but instead can simply construct a portfolio of broad, market-tracking ETFs. By focusing on asset allocation rather than attempting to "beat the market", investors need to get only three things right:

1. choosing a reasonable initial asset allocation;
2. rebalancing periodically;
3. minimizing taxable capital gains by not churning their portfolios and through tax-loss selling.

Those three tasks were the subject matter of the middle section of my free online book on investing with ETFs, The Radical Guide to Investing. My argument was straightforward: with only 10 or 11 ETFs you can build a highly diversified portfolio; you can take care of asset allocation yourself, and you only need to rebalance once a year.

By buying and managing a portfolio of ETFs yourself in an online brokerage account, you save yourself the asset-based fees charged by brokers, financial planners, and "asset allocation" mutual funds. The asset-based fees you'll save - perhaps 1% or 2% per year - become really signficant when compounded over time.

But the reaction to The Radical Guide to Investing was surprising. Many readers found the idea of allocating their assets to 10 or 11 ETFs overwhelming. So I included a low-maintainence ETF portfolio with fewer ETFs.  But even that didn't help - tons of readers emailed me to ask for advice about asset allocation, and it became clear that many people - even smart, educated people - just don't feel comfortable managing their own investments.

In which case, if you fall into that category, you'll have to bite the bullet and pay up for someone else to manage your portfolio for you. Should they do it with index funds, including ETFs? Absolutely. Index funds outperform actively managed mutual funds, and trying to beat the market with stock picking is a losing strategy in aggregate. So you have three options:

1. Use a money manager who will charge you a percentage of assets under management to run an ETF porfolio for you.
2. Choose a mutual fund, such as a "Lifecycle Fund", to do the same thing, paying a percentage of assets in the form of an annual expense ratio.
3. Use an automated ETF asset allocation program, like Ameritrade's Amerivest.

Using a money manager has benefits - it may be more tax efficient, and the manager should be able to take into account your wider financial circumstances, such as whether you own your house and whether you have debts. But it may be more expensive. Lifecycle funds and funds of ETFs are simple and could be cheap. And automated ETF allocation programs like Amerivest are cheap and efficient, but may ignore some of your needs and have other limitations. The key is to shop around for the best product at the lowest cost, and yes, that might be a fund of ETFs or a lifecycle fund.

Having said that, there are two risks with funds of ETFs and "Lifecycle" funds:

1. They may not focus on asset allocation for term investing, but short term trading. In that case, they'll churn their portfolios too much with the result that you'll get tax bills, and they may trail the market. That seems to be the explicit aim of the MetLife funds.
2. Some investors will mistakenly try to "diversify" by investing in multiple funds, instead of handing over their entire savings to a single fund which will handle asset allocatation and diversification for them. If you include a fund of ETFs or a lifecycle fund in a porfolio of funds, you'll end up with a mess in asset allocation terms.

My gut feeling is that most do-it-for-me investors would mess up with funds of ETFs and lifecycle funds, and end up treating them like any other mutual fund. They'd do much better with a money manager that charges reasonable fees (ideally below 1%) or Amerivest.