Should You Buy ETFs of ETFs?

PowerShares just launched three fund-of-funds ETFs, which means they're ETFs that own other ETFs:

The three are:
  • PowerShares Autonomic Growth NFA Global Asset Portfolio (PTO)
  • PowerShares Autonomic Balanced Growth NFA Global Asset Portfolio (PAO)
  • PowerShares Autonomic Balanced NFA Global Asset Portfolio (PCA)

The names are indistinguishable to me but PTO is the most aggressive at 90% equities and 10% other stuff (combo of fixed income, commodities and currencies). PAO is the middle of the road at 75% equities and 25% other. PCA is the most conservative at 60% equities and 40% other.

The three funds own different mixes of essentially the same ETFs (there are a couple of differences), and track indices recently created by New Frontier Advisors. They all target specific allocations which will be reallocated quarterly, but the prospectus allows for more frequent rebalancing to occur if something truly dramatic happens in the markets like, perhaps, a 1987-like crash.

All three funds charge 25 basis points plus the respective fees of each of the underlying funds within.

The equity allocation of all three is very intriguing, because all three favor foreign stocks over domestic; PTO 49% foreign to 41% domestic, PAO 39% to 36% and PCA 31% to 30%.

PowerShares Dynamic Developed International Opportunities Portfolio ( PFA) is a favorite of New Frontier Advisers as it constitutes 22% of the aggressive PTO, 15% of the middle of the road PAO and 7% of the conservative PCA. PFA uses a qualitative screening process to sort through foreign stocks to find names that should outperform.

Because New Frontier Advisors' process for inclusion is proprietary, it isn't clear why PFA seems to be such an overwhelming favorite. PFA listed last July and has tracked very closely to iShares MSCI EAFE Fund ( EFA). PFA's back test was phenomenal, which perhaps contributed to the decision.

All three funds of funds take in domestic and foreign equities, market caps of all sizes, emerging markets, REITs, commodities, currencies, domestic bonds of varying maturity and quality and foreign bonds. None of the funds make narrow bets on a single country, sector or theme. The choices for inclusion are not limited to PowerShares products but most of the funds are from PowerShares.

There is no question the funds are diversified -- they each own between 27 and 30 funds. Not surprisingly, all three funds back-test very well in terms of performance and volatility. (If they were bad, there would be no funds.)

Because most of the funds owned within are fairly new, this must mean that NFA did its back test using other back tests. It makes sense to wonder about a second-derivative effect that could make the boilerplate about past performance particularly relevant.

Despite the issues raised above, I think the funds hold some promise. I do discount that back test, the holdings of the three funds are well put together and do offer a reasonable chance for a successful risk-adjusted return. The realistic risk is not that the funds blow in some sort of catastrophe (unless that is what the market does), but that they end up looking a lot like iShares MSCI ACWI Index ( ACWI) which, if that were the case, would simply mean a little too much in fees paid as opposed to financial ruin.

These are the first ETFs of ETFs. If they successfully attract assets, there will be other funds in the space that could turn out to be better mousetraps. If PTO, PAO and PCA do end up offering utility, it might tough to recognize what the utility might be in any short period of time.

I suspect that the value, if there turns out to be any, would come over an entire stock market cycle -- which is typically how much time is needed to assess this sort of diversification.
At the time of publication, Nusbaum had no positions in the securities mentioned, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.