We will end our look at exchange traded funds (ETFs) with a few words on fund of funds.
Fund of funds are also available with mutual funds. My comments apply equally to them.
Fund of Funds
As the name indicates, an investor purchases an ETF (or mutual fund) whose holdings consist solely of investments in other ETFs (or mutual funds).
In this sense, it is the same as life cycle ETFs. However, fund of funds maintain their stated asset allocations, they do not adjust the mix over time.
Or similar to ETF wraps. But with less flexibility regarding changing asset allocations within the overall fund.
For example, consider the iShares Morningstar Multi-Asset Income ETF. It invests in a multitude of iShare funds (10 at the time of writing this post) aiming for a target asset allocation of 60% bonds, 20% stocks, and 20% alternative assets.
Advantages
Simple
I think simplicity is the primary advantage.
You do not need to buy multiple investments in order to create a diversified portfolio. You simply purchase one that matches your desired asset allocation. Further, the fund of funds automatically adjusts its holdings to maintain the stated mix. Instead of monitoring and assessing many investments, you only need to track the one ETF.
Relative Cost Effective Diversity
Secondly, because fund of funds invest in other ETFs, the holdings are relatively cost effective and efficient investments. Relative, that is, compared to active management strategies or holding mutual funds.
Plenty of Options
Thirdly, there are a wide variety of fund of funds available. You should be able to find one that meets your specific investment objectives. Whether that be a simple split between cash, fixed income, and equities, or something more complex.
Of course, if your target asset allocation changes, and it will over time, you may need to sell the entire fund of funds. Rather than just fine tune a few of the sub-funds to meet your new needs.
Disadvantages
Management Fees
For me, a problem with fund of funds is always the incremental costs involved.
A major advantage of ETFs, in general, is their relatively low expense ratios. But as complexity increases, fees also rise.
Also, you need to watch for double dipping. The investments held by the fund of fund are also ETFs (or mutual funds), which have their own fees and expenses. Given increased competition, often these are adjusted down, but there is still the possibility of paying twice for the same service.
Be sure to compare annual fund of fund costs versus investing in the individual funds that make up the fund of funds before committing.
Potentially Not the Best Investments
It can also mean that the fund is not investing in the best available ETFs. Rather, the prime criteria for ETF selection is the issuer of the individual ETF.
In the iShares Morningstar Multi-Asset ETF I linked to above, all 10 sub-funds are iShare ETFs. Which makes sense given it is an iShare fund of funds. But are all 10 sub-funds the “best in class” that you would buy individually?
There are differences in performance and costs between different ETFs within the same category. I would rather select the best available ETF in a specific asset class, not simply choose the ETF because it is from the same company as the fund of funds.
Conclusion
In general, I tend not to use fund of funds. It is not usually difficult to set up a target asset allocation and choose “best in class” ETFs from across a variety of issuers. That way, I get the best individual investments and save some costs.
That said, there may be niche markets or areas where it does make sense to use a fund of fund. As competition for client money continually increases, ETF issuers are reducing/eliminating double dipping and trying to keep costs in line.
The key is to find strong investments that meet your personal objectives on a cost effective basis. That may be a fund of fund. But more often I think, you are better off building your portfolio from individual ETFs.
