Mutual funds and exchange-traded funds have long been popular as cost-effective one-stop shops for diversifying a portfolio without having to buy a broad array of stocks or bonds.
The strategy has evolved one step further, and investors can tap into instant diversification through a fund that owns other funds. These funds of funds can also offer greater liquidity than their underlying holdings. Typical examples include mutual funds that hold other mutual funds or ETFs, and ETFs that own other ETFs. Target-date funds are often funds of funds.
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Funds buy other funds for the same reasons investors buy them. In addition to quick diversification and good liquidity, funds can be less costly than buying the individual underlying assets because they can all be bought in one transaction rather than paying for individual trades that may have a greater bid-ask spread.
There can also be tax efficiencies, such as from the greater flexibility that ETFs have to change their portfolios without creating a taxable event. And a fund of funds can provide more diversification because it owns multiple funds with different index methodologies.
“For a lot of people, they do want the diversification,” says Christian Magoon, CEO of Amplify Investments and founder of YieldShares.
The Amplify YieldShares Prime 5 Dividend ETF (ticker: PFV) owns the five highest-ranked U.S. dividend ETFs as per the Prime 5 U.S. Dividend ETF index.
A person trying to copy that strategy on their own by buying each of these ETFs would end up getting hit with multiple trading fees throughout the year if they wanted to rebalance the portfolio to keep each fund weighted at around 20 percent apiece, Magoon says. They would also get taxed when they sold shares of ETFs that had appreciated.
A fund of funds provides automatic buy-and-sell discipline, he says.
While funds of funds provide a convenient option for investors to get diversification without having to build their own portfolio, there are some things to watch out for, says Jeff DeMaso, co-editor and director of research for the Independent Adviser for Vanguard Investors newsletter.
Investors should look to keep costs low and remember their objective, he says. For example, there are funds of funds whose aim is to offer protection against inflation by investing in funds that buy Treasury inflation-protected securities, real estate, commodities, emerging market debt and floating rate loans, DeMaso says.
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There are also funds that do this by investing in the underlying assets, and there may not be a particular advantage in funds of funds over regular funds, he says. Just look at the fees, DeMaso adds.
Fees are the most common concern about a fund of funds, Magoon says.
Investors have to pay a fee to own the fund itself, and the fund has to pay fees to own the funds. As a result, fees on fees is a concern, but it doesn’t mean a fund of funds is never a good idea, Magoon says. Investors should look at the total fees and how they compare to the competition, he says.
Also, a fund of funds can get overbalanced. If the managers of the individual ETFs overbalance a certain asset, that concentration risk can be compounded, Magoon says.
There are some that only invest in their own companies’ funds. That can lead to questions about whether the funds they’re holding are really the best of breed. “A nonproprietary fund of funds is a good sign,” Magoon says.
And because funds of funds are so diversified, they can end up closely matching an index. The more funds they have in their portfolio, the more closely they can resemble an index, DeMaso says.
In those cases it doesn’t make sense to pay an active management fee for what ends up being simple index matching, he says.
Although the big benefit of a fund of funds is the diversification it can provide, broad diversification can make it difficult to know what is in that investment because of all the needed research, says Matt Schreiber, president of WBI Investments, whose WBI Tactical Income Shares ETF (WBII) buys investments including ETFs that invest in Treasurys and high quality corporate bonds.
For example, one fund could have 50 equally weighted holdings while another could have half its holdings in large companies, meaning it would not be as diversified, he says. Of course, the latter could end up doing much better than an index, but it could do a lot worse too, he adds. And the former could end up not performing as well a market capitalization weighted index.
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Investors also should think about their own financial situation as they consider a fund of funds, DeMaso says.
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Target-Date Funds: Why Investors Should Have a Fund Full of Funds originally appeared on usnews.com
