The fund-of-funds ETF structure provides an efficient and economical approach to the implementation of many investment strategies. Although critics often complain that fund-of-funds ETFs only put fees on top of fees, the reality is often quite different, making the structure a welcome addition to the investment world.
Typically, an ETF directly owns the securities in the index it is tracking. For example, the SPDR S&P 500 ETF (NYSEARCA:SPY) owns all 500 stocks in the index. When the index adds or removes a stock, the ETF does the same thing. However, a fund-of-funds ETF owns other ETFs instead of owning the underlying stocks, bonds, or other securities directly. Why do they do this? For the same reason you buy ETFs. It is much more efficient and cost-effective to buy a single S&P 500 ETF than it is to buy all 500 stocks in the S&P 500 in their proper allocations and to manage all the index changes.
The accompanying diagram illustrates the concept. In this example, ETF "A" is a fund-of-funds ETF that has only three holdings. Each of those holdings are traditional ETFs that directly own the underlying securities. Let's assume ETF "A" is pursuing a traditional 60/40 asset-allocation strategy of having 60% invested in stocks and 40% invested in bonds. It also makes the further allocation of having two-thirds of its stocks in U.S. companies and one-third in foreign equities.
For its 40% U.S. stock exposure, ETF "A" could buy the Vanguard Total Stock Market ETF (NYSEARCA:VTI), or it could buy the 3,578 stocks that VTI owns. For its 20% foreign equity allocation, ETF "A" could buy the Vanguard Total International Stock ETF (NASDAQ:VXUS), or it could buy the 6,060 securities that VXUS owns. For its 40% bond allocation, ETF "A" could buy the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG), or it could buy the 6,086 bonds and securities that AGG holds.
Therefore, ETF "A" has the choice of buying three ETFs, or it could buy all 15,724 stocks and bonds that those three ETFs are holding. Most of you would agree that buying the three ETFS would be the most cost-effective and efficient approach, even if those ETFs came with their own expense ratio.
If you are not yet convinced, then think about what happens when it is time for the annual rebalancing. Over the past year, the three components of this asset-allocation strategy would have grown at different rates, leaving it with 43% in U.S. stocks, 21% in foreign stocks, and just 36% on bonds.
To rebalance back to its 60/40 allocation, a portion of all 9,638 stocks will need to be sold, and 6,086 bonds will have to be purchased. Each of those transactions will have a broker commission, and more than 6,000 of them will be on foreign exchanges. However, with a fund-of-funds ETF structure, shares of just two ETFs need to be sold, and additional shares of one bond ETF need to be bought.
Depending on how much fine-tuning a given strategy requires, fund-of-funds ETFs might hold a few as one or two ETFs and as many as 20 or more. Common investment strategies using the fund-of-funds structure include asset allocation, currency hedging, market rotation, and tactical approaches. Examples of each are provided below.
Asset Allocation: A hypothetical asset-allocation example is described above. A real-life example is the iShares Core Growth Allocation ETF (NYSEARCA:AOR). It currently holds 10 other iShares ETFs with about 62% in stock and 38% in fixed income. It has a net expense ratio of 0.25%, which includes the 0.09% weighted expense ratio of the 10 ETFs it holds.
Currency Hedging: Most currency-hedged ETFs use a fund-of-funds structure. The iShares MSCI EAFE ETF (NYSEARCA:EFA) is a well-established international ETF with $64 billion in assets, holding 935 foreign stocks. Three years ago, when iShares introduced the currency-hedged version, the iShares Currency Hedged MSCI EAFE ETF (BATS:HEFA), it chose a fund-of-funds structure. For every $100 that is invested in HEFA, $99.73 of it goes directly to EFA. HEFA then uses the other 27 cents to establish the currency-hedging positions.
Market Rotation and Tactical Strategies: Many sector rotation, tactical income, and hedge-fund replication ETFs use a fund-of-funds structure. These strategies tend to focus on industry groups, bond market segments, and asset classes instead of individual stocks. Since their changes tend to be frequent and involve entire sector or bond segment changes, the efficiencies of a fund-of-funds structure can be beneficial.
Examples of ETFs in this group include the PowerShares DWA Tactical Sector Rotation (NASDAQ:DWTR), which typically holds four ETFs, the iShares Yield Optimized Bond ETF (NYSEARCA:BYLD) with seven ETFs, and the ProShares Morningstar Alternatives Solution ETF (NYSEARCA:ALTS) with seven ETFs.
The fund-of-funds structure is not limited to ETFs. The terminology was first used in the hedge fund industry, where hedge funds owning other hedge funds is common. Additionally, many hedge funds own mutual funds and ETFs. Some mutual funds also use a fund-of-funds structure where they might own other mutual funds, ETFs, or both. Fund-of-funds ETFs only buy other ETFs - not mutual funds or hedge funds. This is because the intraday pricing and trading of ETFs requires that its underlying securities can also be priced throughout the day.
There are other items to be aware of when it comes to fund-of-funds ETFs.
Expense Reporting: The expense ratios of ETFs are required to include the expense ratios of any ETFs they own. These are reported as "acquired fund fees" and represent the asset-weighted expenses of the underlying ETFs. A fund-of-funds ETF's overall expense ratio is the sum of the acquired fund fees plus its own expenses.
Asset Adjustments: ETF industry statistics require adjustments to avoid double counting in the assets and fund flows of fund-of-funds ETFs. In the diagram above, if ETF "A" has $100 million in assets, those assets are eventually spread across ETF "X," ETF "Y," and ETF "Z." All four ETFs report their assets, and the figures for "X," "Y," and "Z" will reflect the $100 million invested in "A" that flowed through to them. However, ETF "A" will also report that it has $100 million. Therefore, the assets of ETF "A" need to be removed from any totals, or else that $100 million will appear to be $200 million.
The same type of adjustment is needed for fund flows. If "A" gets $10 million of new inflows, then it will also show up as $10 million of inflows spread across "X," "Y," and "Z." Even though all four ETFs received inflows, the inflow to "X," "Y," and "Z" was the same money that flowed into "A." Without the proper adjustment, any rollup of individual inflow figures will appear to be $20 million instead of the actual $10 million.
U.S. markets currently have more than 90 fund-of-funds ETFs listed for trading. The structure provides an economical and efficient approach to implement many investment strategies by taking advantage of the management, infrastructure, and the benefits of scale provided by the underlying ETFs.
Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.