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Funds of ETFs Can Work for You

You get the benefits of diversification, but lose other advantages of investing in ETFs.

Exchange-traded funds are so hot that even mutual funds are buying them.

According to Morningstar, there are currently 23 funds that invest the majority of their assets in ETFs, which are portfolios of securities that trade throughout the day on an exchange. Most have been launched in the past 12 months. Eight are listed as target-date funds, which automatically rebalance into a more conservative mix of investments as investors approach retirement age. But all of them employ some kind of asset allocation strategy.

ETFs offer a number of advantages over mutual funds, including low costs, transparency and tax efficiency. But it's debatable whether funds that invest in ETFs, or "funds of ETFs," have any advantages over funds of mutual funds.

For people who have neither the time nor inclination to do their own investment research, both funds of mutual funds and funds of ETFs can fill a need -- the fund manager does all of the work for you. In the case of target-date funds, which are retirement-planning vehicles, the asset allocation will shift over time, lightening up on stocks and buying more bonds, as investors age.

Target-date funds and other kinds of asset-allocation funds received a big boost from the Pension Protection Act of 2006, which allows employers to automatically enroll employees in 401(k) retirement plans, increase their savings over time, and put their assets in sensible long-term investments.

This kind of one-stop shopping can be cost-effective if done by a firm such as

T. Rowe Price

(TROW) - Get Free Report

, which packages its own reasonably priced funds and doesn't charge a sales commission upfront.

"If you don't know what you're doing and you need to be protected from yourself, that can be money well spent," says Jeff Tjornehoj, senior research analyst at Lipper.

He adds that funds of ETFs are less likely than funds of mutual funds to be locked into investing in other products offered by the same firm, since few mutual fund firms have their own stable of ETF products. So they "can potentially get a best-of-breed strategy."

Funds of ETFs also can be helpful for people who have a relatively small amount of money to invest but want a diversified portfolio. It would take tens of thousands of dollars to build a diverse portfolio of ETFs, but with funds of ETFs you can get this kind of exposure for an initial investment of as little as $1,000.

The downside is that when you invest in ETFs through mutual funds, you lose much of the advantages of these products.

Because ETFs track indices, investors always know what they're holding. By comparison, mutual funds only have to report their holdings once a quarter, and if they are actively managed, the information can quickly become outdated. And unlike mutual funds, which can only be bought or sold once a day at the market's closing price, ETFs trade throughout the day. But investors lose these benefits when they buy funds of ETFs -- although the fund manager still enjoys them.

Another advantage to investing in ETFs is that you don't pay capital gains taxes until you sell them. By comparison, mutual funds are required to distribute any capital gains generated on their holdings once a year -- regardless of how long you've owned the fund. The same is true of funds that invest in ETFs.

Finally, when you invest in ETFs via a mutual fund, you are paying an additional layer of management fees, eating into your returns. That's to be expected; after all, in addition to the ETFs themselves, you're getting investment advice. What you might not realize is that you, the investor, are paying not only the mutual fund's expense ratio, which can range from 1% to 2.5%, but the expense ratios of all of the ETFs it holds.

Even more surprising is that while funds of ETFs hold less-expensive products than funds of mutual funds, they actually charge more to run. According to Morningstar, the average fund of ETFs has an expense ratio of 1.56%, compared with 1.45% for the average fund of mutual funds.

On top of that, since most funds of ETFs can only be purchased through an investment adviser, you're also paying him or her a fee.

This is the hardest fee to swallow. Any investment adviser worth his salt should be able to create an asset allocation plan for you. Basically, you pay this guy a front-end load of around 4% to pass you on to another money manager. If you really want a fund of ETFs, get rid of this useless middleman and buy the fund on a fund supermarket platform.

"People pay us a fee to choose the ETFs, so we don't want to pay another third party and add another layer of fees," says Mike Bartlow, a registered investment adviser at Money Map Advisors. The Houston firm manages portfolios built with ETFs and charges an annual fee no higher than 0.75%. "I wouldn't recommend these

funds of ETFs to a client. For any actively managed mutual fund in any given asset class, there is now a rules-based ETF index fund alternative that not only has higher returns, but eliminates capital gain distributions with fees typically 50% lower."

If you've read this far and you really want a fund of ETFs, the best move is to join a fund supermarket platform and save some money by buying it yourself.

The best and oldest of the bunch is the $708 million


(CLSAX) - Get Free Report

Amerigo Fund(CLSAX) from CLS Investment Firm of Omaha, Neb. The fund, which was up 6.5% for the year through Monday compared with 2.44% for the

S&P 500

, overweights asset classes such as large-cap growth and international stocks.

While considered a large-cap blend by Morningstar -- which gives the fund four stars -- Amerigo holds a mix of large stocks, small stocks and emerging markets in about 25 ETFs. It has no constraints and the portfolio managers go wherever they think the returns are.

Its top five holdings as of July 31 were the

iShares Russell 1000 Growth Index

(IWF) - Get Free Report


iShares MSCI EAFE Index

(EFA) - Get Free Report


iShares MSCI Emerging Markets Index

(EEM) - Get Free Report


Vanguard Mid-Cap ETF

(VO) - Get Free Report


iShares Russell MidCap Growth Index

(IWP) - Get Free Report


The fund has an expense ratio of 1.41% and doesn't charge a load or sales commission. The minimum investment is $2,500.