From the July 2011 issue of Research Magazine • Subscribe!

July 1, 2011

When ETFs Own ETFs

Are ETFs that own other ETFs useful portfolio tools or do they undermine the asset allocation services provided by financial professionals? This is an important question to consider, especially as the number of ETFs owning other funds increases.

While the ETF category for “fund of funds” (FOF) is still small, it’s nonetheless steadily climbed over the past few years. In 2009 assets of $100 million have grown to almost $1 billion today. At the end of April, there were 23 FOF ETFs with $923 million in assets, according to the National Stock Exchange. The three largest ETF providers with the most assets in this category are iShares ($423 million), AdvisorShares ($200 million) and IndexIQ ($172 million).

Within the ETF universe, FOF products can be grouped into two basic categories: ( 1) target dated retirement funds, and( 2) strategy funds.

Target Dating

The retirement market is one place where the FOF ETF solution has real traction. “We use ETFs which are structured as fund of funds in our 401(k) program because such funds are packaged solutions at that people can understand,” states Daniel Weiskopf, principal at Forefront Advisory in New York City. “We believe that the first priority to solve part of the issue of getting people to buy into retirement programs is to structure programs that people can understand.”

Black Rock’s iShares unit offers seven FOF ETFs linked to target date benchmarks built by Standard & Poor’s.

The funds have target dates that begin with 2010 (TZD) and run in five-year increments all the way to 2040 (TZV).
The main asset classes represented inside S&P’s target indices are domestic and international stocks, domestic real estate, fixed income and cash. Each asset class is represented by a corresponding iShares ETF. For example, the 2020 ETF (TZG) holds the bulk of its market exposure to the iShares S&P 500 Index Fund (IVV) and the iShares Barclays Aggregate U.S Bond Index Fund (AGG) while the rest of the portfolio is allocated among the iShares Barclays Short Treasury Bond Fund (SHV), iShares Barclays U.S. TIPS Bond Fund (TIP), iShares MSCI EAFE Index Fund (EFA), iShares MSCI Emerging Markets Index Fund (EEM), iShares S&P Small Cap 600 Index Fund (IJR), iShares S&P Mid Cap 400 Index Fund (IJH), the iShares Cohen & Steers Realty (ICF) and cash.  

The total all-in expenses for the iShares FOF target dated ETFs, after fee waivers, range from 0.29 to 0.30 percent annually.  

In the long run, the best application for target-dated ETFs is within 401(k) plans, but paradoxically most employer sponsored retirement plans don’t offer ETFs. Despite these shortcomings, many analysts still see ETFs taking market share from traditional mutual funds in the 401(k) space.

Active Management

The Dent Tactical ETF (DENT) is another example of an FOF ETF, but with a tactically oriented actively managed investment approach.

DENT aims for long-term capital growth by investing in other ETFs across several different asset classes such as domestic and foreign equities, domestic or foreign fixed income or commodities. Using Harry S. Dent Jr.’s research methodology, DENT’s portfolio manager analyzes economic and demographic analysis, the overall trend of the U.S. and global economies and consumer spending patterns. The manager tries to own the strongest performing asset classes and apply it to the fund’s target allocation.

Good as that may sound, DENT’s performance has struggled. Since its 2009 inception, it’s posted a 5.76 percent gain compared to a 27.90 percent gain for the S&P 500. DENT charges a net expense ratio of 1.50 percent.

Strategic Planning

Choosing an FOF ETF for clients may make sense, particularly when a certain investment strategy is expensive or difficult to replicate on your own. “I do like the idea of an ETF of ETF from the commission standpoint,” says Kirk Kinder, a CFP with Pickett Fence Financial in Baltimore, MD. “An investor pays one commission to get a handful of ETFs, rather than pay several commissions to build the portfolio.”

One ETF that takes this approach is the ALPS Equal Sector Weight ETF (EQL).

EQL owns each of the nine Sector SPDR ETFs in equal proportions, or by 11.1 percent, within the fund’s portfolio. The basic idea is to have exposure to the S&P 500, but without the occasional sector distortions that occur when an industry sector gets hot. Over the past decade alone, financial and technology stocks have exercised their dominance over the S&P’s movements for both good and bad.

Buying all nine Sector SPDRs in equal portions and reweighting them quarterly to maintain an equal weight strategy is simply not feasible from a cost or portfolio management angle. On the other hand, having automatic rebalancing and weighting done inside EQL for an annual fee of 0.55 makes it a more reasonable choice.
Other FOF ETFs are real head scratchers.

The $222 million PowerShares CEF Income Composite Portfolio (PCEF), for instance, owns a portfolio of roughly 116 closed-end mutual funds. Over the past decade, many advisors have flocked away from closed-end funds to ETFs to avoid the persistent premiums and discounts associated with the former not to mention the substantially higher management fees. But PCEF dives in head first.

The fund’s main selling point, it seems, is to offer a diversified portfolio of closed end funds (CEFs) within an ETF shell. Conceptually it sounds all right but what about in real life? Since most CEFs are already diversified vehicles, owning too many of them can contribute to the problem of overdiversification where one holding negates the other because of needless duplication. Interestingly, PCEF has been handedly outperformed by the total U.S. stock market over the past year and its annual expense ratio is 1.62 percent — expensive by ETF standards.

Certain FOF solutions may not necessarily be solutions and that’s why advisors need to ask questions before jumping in.

“One problem we would look for is whether the need to be FOF is driven by simplicity or is it just an elegant more expensive wrapper designed to attract assets,” says Weiskopf. “What specific purpose exists for an investor to gain by such a wrapper?” Weiskopf concludes: “So long as an ETF is transparent with its holdings and trades efficiently with a reasonable expense ratio compared to a mutual fund, we think investors will benefit.”

Finding a Fit

Advisors should survey their clientele to see where FOF ETFs might be a good fit. “Smart advisers will see these types of ETFs as a way to work with smaller clients and help them grow into larger clients, especially when working with multiple generations within a family,” says Larry Steinberg, president of the Steinberg Financial Group in Scottsdale, Ariz.  

The ETF of ETF could be a vehicle for younger generations, especially those who are hands-on about investing.
“I think that the Gen X and younger generations are much different than the boomers and WWII generations,” explains Kinder. “The young and wealthy under 50 years of age (defined as $500,000 in investable assets) are using social media to determine asset allocation or find advice. They feel they can do as well or better than most advisors and save considerable amount of money by cutting out the advisor fee.”

Regardless of your views on this trend, it’s up to advisors to prove to prospects and clients they have the right investment solutions.

Another place where FOF ETFs have a bright future is inside retirement plans.

Steinberg adds: “I see FOF ETFs as being very important down the line as ETFs come to dominate the 401(k) marketplace, especially once they are allowed to become QDIA’s or Qualified Default Investment Alternatives.”

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