ETF of ETFs: What It Means, How It Works, Limitations

What Is an ETF of ETFs?

An ETF of ETFs is an exchange-traded fund (ETF) that tracks other ETFs rather than an underlying stock, bond, or index. Like a fund of funds, this approach provides investors with a method for investing in multiple strategies with a single product. It combines the cost and transparency advantages of the traditional ETF structure with the research and analysis of an actively managed fund.

Many well-established providers like State Street and iShares have hopped on the ETF of ETFs bandwagon through new product offerings that combine different asset classes or rotate between sectors.

How ETFs of ETFs Work

An ETF of ETFs is a type of security that provides more diversification than a regular ETF. They can be constructed by leveraging certain desirable factors such as various risk levels, time horizons, or industry sectors.

As a result, these ETFs of ETFs can give an investor broader exposure to many sectors and asset classes. On average, traditional ETFs have lower fee structures than managed mutual funds that involve more research and analysis. An ETF of ETFs aims to strike a delicate balance between the two (lower cost and better research) and beat a standard benchmark index.

The concept of an ETF of ETFs finds its roots in traditional target-date and other asset allocation funds that seek to provide simple investment solutions and follow the fund-of-funds (FoF) strategy seen in the mutual fund and hedge fund industry. An investment in a quality multi-strategy fund is appropriate for novice investors who lack the skill or resources to construct an attractive portfolio.

The advantages don't end there. This novel approach affords investors instant diversification, low fees, and exposure to broad-based strategies across different asset classes. In the event of a downturn, a well-diversified portfolio employing various strategies can help keep losses to a minimum.

Limitations of ETFs of ETFs

While many of the newest ETFs of ETFs claim to simplify investing, they often employ complex mechanisms that make it difficult to understand the various offerings in the fund. What's more, the products are often highly concentrated and tend to exhibit greater turnover than most actively managed funds.

That means if the market turns against the fund, it could quickly become the largest holder of a thinly traded ETF. While cheaper than mutual funds of funds, ETFs of ETFs are also more expensive to own than traditional ETFs due to the added layer of management and fees.

A more straightforward—and cheaper—approach involves constructing a portfolio of individual stock and bond ETFs. Moreover, investors must rely on the skill of the portfolio manager to make critical asset allocations and tactically adjust the portfolio on a timely basis. Most empirical research finds a hands-off, buy-and-hold approach tends to outperform a stock-picking strategy.

The Bottom Line

ETFs of ETFs provide investors with exposure to a broad array of investments in a simple format. Rather than having to invest in two, three, or more ETFs, an investor can choose one ETF that invests in many ETFs, gaining that broad exposure. This also reduces costs as the investor is only paying one expense ratio as opposed to multiple. ETFs of ETFs provide simplicity, broad diversification, and cost benefits.