Picking a Fund of Fund ETF

By Oct 14, 2010, 2:11 PM Author's Blog  

The explosion in ETFs enhances investment strategy options on a number of levels. One is that ETFs that hold a mix of other ETFs is now a growth industry. Indeed, as the population of strategy-specific ETFs rises, so too do the possibilties with ETF fund of funds. But as with any other ETF decision, picking a fund of fund ETF requires attention to detail. There’s already quite a few of these products trading, and more are coming. The strategies range from the exotic to the simple. Predictably, some are worthwhile, some aren’t. The first question for all of these funds: Is there any possibility for value-added management alpha? If the answer is “yes,” then the second question: Is the fee reasonable?

As one simple example of how you might consider these questions, consider the recently launched OneFund ETF (ONEF). There are many other ETF fund of funds to consider, but since this product’s strategy is quite basic, it lends itself to a quick test. According to the fund’s website, One Fund “is a simple and easy way to own a globally diversified, professionally managed stock portfolio in a single fund.” The website also explains,

By investing in One Fund, you have the potential to gain exposure to over 5,000 different companies in the U.S. and around the world. This underlying diversity in the Fund’s composition may reduce volatility and increase the return potential for investors.

So while you are buying a single fund – One Fund – you are really buying a globally diversified stock portfolio in a single investment.

One Fund is effectively a core holding for capturing the global equity market beta. Conceptually, the strategy has merit. Indeed, a core global equity fund can be used as an anchor around which investors can customize a global stock market allocation strategy. You could, for instance, use the fund in a core-satellite approach, owning One Fund as the core plus some mix of additional funds targeting specific pieces of the global equity market and, perhaps, managing the satellite allocation dynamically.

But while One Fund’s focus on providing a core global equity product is sound, there are other choices to consider. One is the Vanguard Total World Stock Index ETF (VT). Another is iShares MSCI ACWI Index (ACWI). Both VT and ACWI invest globally, owning stocks from the U.S. and foreign developed and emerging markets, weighting shares by market cap. The goal in both VT and ACWI is to be comprehensive, tapping the market value-weighted portfolio of all the planet’s stocks. If that sounds like One Fund’s strategy, you’re right—the three funds are more or less equivalent.

One clue is that the three funds move with a high degree of similarity. Although One Fund has a short history (it was launched this past May), comparing the product with the older VT and ACWI since then suggests that this trio share a relatively high correlation, as a graphical history of fund prices suggests.

Another clue that that the three funds are similar comes from examining One Fund’s portfolio, which is listed on its web site. As of October 14, One Fund held five ETFs: four Vanguard ETFs and one iShares fund. This brings us to the key question: Is it worth paying One Fund an additional fee to hold ETFs you can buy yourself? One Fund charges a management fee of 35 basis points for this service. You’ll also pay the expense ratios charged by the five ETFs held in One Fund’s portfolio. Overall, One Fund’s total expense ratio is 51 basis points. But if you replicated One Fund’s portfolio yourself, the weighted expense ratio of holding the same five ETFs would come to a bit more than 15 basis points—a rather large discount vs. the 51 basis points you’ll pay to One Fund. Even if you wanted a one-stop fund for owning all the world’s stocks, VT’s expense ratio of 30 basis points and ACWI’s 35 basis points offer less expensive choices.

What’s more, One Fund’s literature explains that its strategy is buy and hold. Accordingly, the opportunity to add value through rebalancing or tactical asset allocation is nil.

Even if you agree that buy and hold is superior, there’s another problem. Holding a portfolio of multiple funds in one product prevents you from engaging in tax-loss harvesting strategies, which could add 50 to 100 basis points on an after-tax basis without taking on additional risk.

The bottom line: It’s not obvious why you would pay an additional fee to One Fund for a simple buy-and-hold strategy comprised of five ETFs that you buy and manage on your own. Replicating this strategy, in other words, is quite easy and doing so offers the potential for significant cost savings/tax reductions over time. In sum, a good idea that’s too expensive. It’s not egregiously expensive, but there’s no compelling reason to pay more for this strategy.

Yes, some fund of fund ETFs may be worth the price of entry, but you have to choose carefully. But the analysis won’t always be so simple. This is a growth industry and many of the new products coming out have a lot of moving parts. Caveat emptor.

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