From the November 2005 issue of Investment Advisor • Subscribe!

Funds of ETFs

Most advisors who have created their own mutual funds use an asset allocation approach, moving monies among different markets in order to enhance return and manage risk. Most of these advisor-managed products hold the bulk of their assets in exchange traded funds (ETFs), which have proven to be great tools for such a strategy.

ETFs offer some important advantages over mutual funds in the fund-of-funds context. High on the list of pros is that they have much lower management fees than mutual funds. They're also not subject to the numerous types of hidden fees common to mutual funds, including front-end sales loads and ongoing distribution (Rule 12b-1) fees. A lack of redemption fees make tactical portfolio adjustments more cost-efficient.

These so-called "funds of ETFs" are seen as a more attractive alternative to targeted-maturity or lifestyle funds, many of which hold shares of traditional open-end mutual funds. For this latter group, the result is often a double layer of fees. Although there are around 400 funds of mutual funds currently being offered, the number of funds of ETFs is much smaller, perhaps totaling a dozen. J.W. Seligman & Co. recently announced plans to roll out target-maturity and lifecycle funds made up entirely of ETFs. MetLife is following with its own ETF-based products.

It should be noted, however, that the most important attribute of any actively managed product is the underlying strategy. An asset allocation approach that has no merit will result in a poorly performing product, no matter how cheap the underlying instruments. In fact, several recently launched funds of ETFs--most notably those that use a market-timing approach--have yielded lackluster results, and more than a few have closed.

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