By Paul Weisbruch

Recently we published a piece on ETF Mutual Funds, which by design are structured as 1940 Act mutual funds, that own individual ETFs as opposed to equities or fixed income securities as their underlying holdings. This article can be accessed on both Minyanville and Morningstar ETFs.

These ETF Mutual Funds are not simply vanilla index mutual funds like that of say Vanguard, like their names may imply, but instead are strategic portfolios designed to provide risk adjusted alpha to the end investor, and are in essence using ETFs strategically and tactically in order to outperform stated benchmarks. Another vehicle that has emerged in recent years are ETFs of ETFs. What exactly is an ETF of ETFs? Simply put, an investor can access the strategies of many different ETFs (equity, fixed income, long, short, commodity, currency, etc.), professionally managed within the wrapper of one ETF. So the end goal of these ETFs of ETFs is somewhat similar to that of ETF Mutual Funds. Today, we have asked leading ETF industry pundits for their commentary on the topic of ETFs of ETFs with a goal of understanding these rapidly evolving products effectively.

First off, Anthony Welch, a portfolio manager for a mutual fund of ETFs, The Currency Strategies Fund (FOREX) which we highlighted in our previous article mentioned above, noted to us that There are three basic reasons to invest in a fund of funds — whether it’s a mutual fund or an ETF: Time, cost, and expertise. Managing a strategy takes time to do correctly and many investors simply have other things to do with their time, such as work at their jobs or play golf.

As far as ETFs of ETFs go, what are the existing options out there for the investor or financial advisor? Ron Rowland of Invest With An Edge notes that there are two categories of ETFs of ETFS, those being 1) Traditional Asset Allocation and 2) Strategy Implementation. He states that examples of products that fall within the first category include ONEF (One Fund), AOA (iShares S&P Aggressive Allocation), AOK (iShares S&P Conservative Allocation), AOM (iShares S&P Moderate Allocation), AOR (iShares S&P Growth Allocation), TGR (iShares S&P Target Date Retirement Income), TZD (iShares S&P Target Date 2010), TZE (iShares S&P Target Date 2015), TZG (iShares S&P Target Date 2020), TZI (iShares S&P Target Date 2025), TZL (iShares S&P Target Date 2030, TZO (iShares S&P Target Date 2035), and TZV (iShares S&P Target Date 2040).

The second category according to Rowland, Strategy Implementation ETFs include products such as those from Index IQ, namely QAI (IQ Hedge Multi-Strategy Tracker), CPI (IQ CPI Inflation Hedged), and MCRO (IQ Hedge Macro Tracker). Additionally, he cites that AdvisorShares’ DENT (Dent Tactical), EQL (ALPS Equal Sector Weight), PAO (PowerShares Autonomic Balanced Growth NFA), PCA (PowerShares Autonomic Balanced NFA GI), and PTO (PowerShares Autonomic Growth NFA Glo) would all fall within this category as well. He notes that PAO, PCA and PTO may also fit within category 1, as these products are somewhat of a hybrid between asset allocation and strategy implementation.

Managers of ETF of ETFs usually hold an assortment of index ETFs that track indices of various sectors or asset classes that the manager wants to have exposure to. At any one time, the manager likely has holdings of several different ETFs, depending on the asset allocation strategy of the manager. For example, the newly launched One Fund (NYSEARCA:ONEF ) holds 5 different ETFs while the AdvisorShares Dent Tactical ETF (NASDAQ:DENT ) holds 10 different ETFs. While both of these are actively-managed ETFs, another set of ETF of ETFs structured as index ETFs are managed by Index IQ, one of which is the IQ Hedge Multi-Strategy Tracker ETF (NYSEARCA:QAI ). QAI tracks an underlying index but the active management in this case is in the index itself, which replicates risk-adjusted return characteristics of hedge funds. The underlying index is made up of 9 ETFs providing long exposure and one fund providing short exposure. So in general, these managers alter their portfolio exposures by changing their ETF weightings, instead investing in individual securities and the managers report their holdings on a daily basis.

One factor that Rowland highlights in regard to the ETFs that fall under category 2 (Strategy Implementation), is related to fees. He states,

The immediate hurdle that these ETFs face is the stigma of double fees. Some investors see paying an ETF expense ratio on top of other ETF expense ratios as an automatic no-no. However, investors are receiving another layer of advice. So the what they really should be focusing on is whether or not they are paying a fair price for that extra layer.

For example, in relation to one of the IndexIQ products, MCRO, Rowland states,

The all-in expense ratio on MCRO is 1.10%, based on a management fee of 0.75% and acquired fund expenses of 0.35%. Most of the category 1 ETFs have lower acquired fund expenses because they are statically allocating to widely followed indexes. Category 2 funds have higher acquired fund fees because they are typically allocating to non-traditional fund indexes including commodities, currencies, leveraged and inverse products. Additionally, the management fees are justifiably higher in this group because the layer of advice they are adding is dynamic as opposed to the relatively static overlay of the category 1 ETFs of ETFs.

In relation to fees, Shishir Nigam of ActiveETFs | InFocus agrees, pointing out that

One thing advisors should be wary of when investing in ETF of ETFs is that they usually have higher expense ratios that most other ETFs. This is due to the fact a major expense for these funds is something called the Acquired Fund Fees and Expenses, which is essentially the sum of the expense ratios for all the underlying ETFs that the fund holds. An investor who puts money in these products is paying two layers of fees the first layer goes to the manager of the ETF of ETFs and the second layer goes to meet the expense ratio of the underlying ETFs. Hence, the advisor should weigh these costs against their promise of performance.

Anthony Welch had the following to say about cost:

Cost is a factor that requires a bit of analysis. An investor that is looking for a simple size/style strategy that requires quarterly or annual rebalances may be able to accomplish that goal on their own with a fairly low cost. However, more dynamic strategies that have daily or weekly changes can have significant transaction costs for an individual portfolio. In this case, spreading the transaction costs over hundreds or thousands of investors makes sense.

In relation to where and how financial advisor can utilize ETFs of ETFs in their practices, Rowland notes that,

Advisors are more likely to utilize one of the category 2 (Strategy Implementation) ETFs of ETFs as part of the overall portfolio they are building for a client. Advisors (and individual investors) will need to consider the cost of getting access to a desired strategy in other formats: mutual funds, hedge funds, etc and/or the cost of doing everything in-house. Additionally, they must determine if they even have the knowledge and expertise to implement the strategy in-house as opposed to sourcing it through other vehicles.

In other words, using ETFs like those from IndexIQ which package hedge fund replication strategies in an ETF wrapper, these may be appealing choices for advisors who do not have the resources nor expertise to select individual hedge funds, or perhaps are limited from doing so due to size constraints, or some in house restriction on the platform/brokerage house level.

In reference to the first category of ETFs (Traditional Asset Allocation) that we highlighted above, Rowland points out that many financial advisors may never use such products for clients. He elaborates,

Advisors are unlikely to ever use ETFs of ETFs that are in the traditional asset allocation category. Much like mutual funds of mutual funds, ETFs of ETFs that follow this approach will be viewed by advisors as being competitive to the services they offer instead of being tools to use in their practice. In short, advisors believe it is their responsibility to do the asset allocation.

Shishir Nigam believes that one reason ETFs of ETFs generally may be appealing to advisors relates to liquidity. He states,

In 2008, many financial advisors were left in a tough spot because the funds they invested client money in, held individual securities that became too illiquid to sell off or even value due to the market conditions. However, when fund managers use ETFs to construct their portfolio instead of individual securities, they are less likely to face such scenarios in times of market stress. This is because of the fact that liquidity for ETFs is determined very different from the liquidity for individual stocks and bonds. ETF liquidity is created by market makers and authorized participants who use creation and redemption units to meet demand for sells and buys an activity that they are obligated to undertake, regardless of market conditions, hence ensuring ETF liquidity. This is in contrast to liquidity for stocks and bonds which depends directly on the demand and supply for that security.

Paul Hrabal, the portfolio manager of ONEF (One Fund) had the following to say about liquidity:

Why we chose an ETF of ETFs? Liquidity and cost. One Fund owns, through the underlying ETFs, nearly 5,000 companies around the world. But we own those companies through other ETFs instead of owning those companies directly. We pay 16 basis points in underlying fund fees. But, we benefit on the cost and liquidity front by not having to manage an extremely large basket of stocks, including some in emerging markets and international small cap stocks that are thinly traded. Market makers are more willing to step in and provide liquidity in our ETF because we own just five highly liquid U.S. listed ETFs from iShares and Vanguard. Its a simple basket for them to price and hedge. There is less need for them to pad the bid/ask spread to cover potential risks and costs. This benefits our shareholders with tighter spreads and more market makers providing liquidity.

Outside of individual portfolios, whether retail brokerage of IRA plans, can these ETFs of ETFs gain traction within 401K plans? This is something we questioned in our previous article about ETF Mutual Funds, as the vehicles seem poised to be embraced in these plans. Ron Rowland notes,

One segment where mutual funds of mutual funds have found success is in 401k plans, where the single selection or default selection simplicity wins out. As ETFs work their way into 401k plan, traditional asset allocation ETFs of ETFs will likely enjoy some success.

Digging deeper into some of the ETF of ETF strategies that we mentioned above, Anthony Welch had the following to offer about DENT (AdvisorShares Dent Tactical).

For investors that follow the writings of Harry Dent and agree with his methodology, this ETF is a convenient way to take advantage of his expertise. Of course, for those investors who don’t agree, this ETF can be shorted as well. While some purists may find the expense ratio on the high side, it is important to consider that there is no more simple and convenient way to access Mr. Dent’s management with minimal capital.

Welch brings up an interesting point, and one that is often lost in the realm of ETFs. Critics of specific ETF strategies can act on this criticism and short the product outright.

In reference to the IndexIQ ETFs that we mentioned earlier, Welch states,

Another example of strategies that were previously difficult to obtain by the average investor is the hedge fund replication strategy ETFs from IndexIQ. These ETFs attempt to provide exposure to Macro (NYSEARCA:MCRO ) and Multi-Strategy (QAI ) solutions used by various hedge funds. The expense ratio is quite low compared to hedge funds, more transparent, and more liquid. The idea is quite interesting as a way to introduce alternative strategies to a portfolio on a cost effective basis. As time goes on, it will be easier to measure the effectiveness of the strategies.

Adam Patti, CEO of IndexIQ, adds:

We use ETFs as the underlying portfolio components in 3 of our ETFs for three reasons; 1) ETFs provide an inexpensive way to capture different asset class exposures, 2) The ETFs we use are highly liquid, and perhaps most important for us, 3) ETFs provide a very transparent way for investors to see (and understand) what is in their portfolio.

1) QAI, our multi-strategy hedge fund replication ETF uses ETFs to capture the asset class exposures common across six hedge fund investment styles. The goal is provide investors the performance characteristics of investing in hedge funds, without the structural impediments of hedge funds themselves, namely their lack of liquidity & transparency and their high fees. QAI is designed to be used as a core component of an investors alternatives allocation.

2) MCRO, our market directional ETF is a global equity alternative that combines the performance characteristics of global macro and emerging markets hedge funds. MCRO is designed to replace a portion of an investors global equity allocation and provides downside protection in volatile markets while retaining upside participation in market rallies.

3) CPI, our real return ETF is designed to provide investors a real return above the rate of inflation with low volatility and is often used within their alternatives allocation. People also use CPI as a short-term bond allocation and replacement for TIPs bonds. The CPI ETF uses ETFs in the portfolio as an efficient way to gain exposure to a variety of asset classes, all of which have embedded inflation expectations.

The newest addition to the universe of ETFs of ETFs is ONEF (One Fund) from U.S. One. The fund’s portfolio manager Paul Hrabal stated to us,

When we decided to bring our investment philosophy to the public we could have chosen either vehicle, an ETF or a mutual fund, to deliver the product. We were a new issuer and had a clean slate with no legacy issues to influence our decision. We chose the ETF structure because from an issuer prospective, it is less costly to administer. There are no distribution fees to be placed on the major NTF platforms and the shareholder servicing costs are virtually eliminated. Our lower costs could be passed on to potential investors. Had we gone with a mutual fund vehicle I estimate our expense ratio would have to be increased from the present 0.51% to well over 1.00% just to cover the added costs. I think the days of high expense ratio mutual funds, sales loads, 12b-1 fees and the like are coming to an end as they should and the low cost of the ETF structure, combined with the clean and transparent trading and reporting will gather an increasingly large share of assets vs. mutual funds.

Anthony Welch is however, critical of the current expense ratio of ONEF, stating,

The strategy is to buy and hold through thick and thin because, according to the website, timing doesn’t work and no one can beat the market. The website cites the popular buy and hold mantra of if you missed the best ten days of the market, you really missed out. The idea that an investor was in the market each and every day for 30 years except the ten best days is quite impossible statistically. In fact, missing the 10 worst days, (another impossible feat), would provide much better results than staying invested. Meaningless stats aside, this is a case where it would be very simple for an investor to build a similar portfolio for half the cost. The fund held five ETFs on 6/2/2010, something even the greenest investor could accomplish in five minutes with around $50 in commissions.

ETFs will undoubtedly continue to evolve as new innovative strategies are thought up by fund issuers such as those mentioned above. As with all ETF products, it pays for the advisor or end investor to do some homework and learn what is inside their given ETF, as it is not a terribly daunting task, and unlike some mutual funds or hedge funds where such an exercise can yield nebulous results, ETFs by their construction are transparent. Some strategies may gain more traction and attention in the marketplace than others, but as with Mutual Funds of ETFs, the industry has come a long way from simply offering equity indexed beta products.

Disclosure: No positions