When ETFs Own ETFs

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.”