Exchange-traded funds are following in the footsteps of the mutual fund industry with the launch of ‘funds of funds.’ While conventional ETFs hold a basket of securities, these funds own a basket of other ETFs. In many cases, they’re actively-managed funds that aim to outperform the market rather than provide exposure to specific corners of the market.
Let’s take a closer look at funds of funds and whether you should consider adding them to your portfolio.
See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.
Adopting a Tactical Approach
Funds of funds have a long history in the mutual fund world, but ETFs of ETFs are a relatively new phenomenon. According to Morningstar, there were roughly 100 ETF ‘funds of funds’ in the U.S. at the end of 2021. Most of these funds focus on asset allocation—serving as a model portfolio in an ETF wrapper—or target specific themes or sectors.
However, recent funds have taken an actively-managed tactical approach thanks to the success of Cathy Woods and other asset managers. Rather than serving as a portfolio-in-a-box, these new funds aim to outperform the market or mitigate risk using a variety of new approaches, turning them into more of a hedge fund than a financial advisor.
The Fairlead Tactical Sector ETF (TACK) builds its portfolio from a universe of 14 ETFs, including risk-on and risk-off funds. Using technical analysis, the fund managers seek to navigate equity market downturns through asset allocation while capitalizing on opportunities identified through various technical analysis signals.
The Innovator Buffer Step-Up Strategy ETF (BSTP) and the Innovator Power Buffer Step-Up Strategy ETF (PSTP) are actively-managed funds of funds that aim to provide risk-managed exposure to the S&P 500 ETF Trust (SPY). They offer a one-ticker solution for an opportunistically-managed buffer strategy through FLEX Options (9% and 15%, respectively).
The NextGen Trend and Defend ETF (TRDF) is another example of an actively-managed ETF of ETFs. The fund managers seek to generate positive returns in significant market declines by investing in ETFs that track the performance of the S&P 500, ETFs that provide the daily inverse return, or short-term U.S. Treasury ETFs, depending on conditions.
Beware of Potentially Higher Costs
Most ETFs charge a management fee, meaning that an ETF of ETFs holder must pay two management fees—one for the umbrella ETF and several for the ETFs in its portfolio. In the mutual fund world, the fund of funds costs are kept down by using mutual funds from the same sponsor. However, that’s not always the case with ETFs of ETFs.
With commission-free ETF trades at many brokerages, investors may want to consider building their own ETF strategies or mimicking these asset managers to avoid these costs. But, of course, the trade-off is that actively managing a portfolio of ETFs negates the core benefit of these funds—saving time by outsourcing management to someone else.
In addition to management fees, funds of funds may experience more taxable capital gains. While conventional ETFs track indexes that rarely change, resulting in few taxable capital gains, funds of funds may incur significant capital gains if they frequently trade or rebalance. That said, taxable gains have been relatively muted thus far for ETFs of ETFs.
Don’t forget to explore our Dividend Guide where you can access all the relevant content and tools available on Dividend.com based on your unique requirements.
The Bottom Line
Actively-managed ETFs have become increasingly popular following the success of asset managers like Cathy Woods. While many active ETFs focus on identifying thematic or asset allocation opportunities, a growing number are taking an ETF of ETFs approach to become an all-in-one option for investors seeking to generate alpha.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
