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Fund Spy
Funds of ETFs leave much to be desired
These funds of funds have a lot of problems to address, including high costs and questionable strategies, before deserving consideration by investors.
By Dan Culloton, Morningstar
Beware of mutual funds promising to let the average investor in on the ETF (exchange-traded fund) revolution. Their pledges are most likely siren songs.
Exchange-traded funds, which are essentially index mutual funds that can be bought and sold like stocks throughout the day on an exchange, have been getting a lot of attention lately. The $162 billion in assets they claim is still a fraction of $7.6 trillion committed to traditional mutual funds, but ETFs continue to increase in terms of total net assets and number of funds available (134 at the end of March).
Investors have been drawn to their low expense ratios, flexibility, and reputation for tax efficiency. ETFs, which are not susceptible to the kind of trading abuses uncovered in the mutual fund industry since last fall, also have won a few converts among scandal-weary investors.
One of the big knocks against ETFs, however, has always been that commission and trading costs can quickly turn their cost advantage into a disadvantage, especially for rapid traders or small investors who want to make regular, monthly contributions to their portfolios. In recent years a couple of small firms have launched no-load funds-of-funds that at first glance appear to put ETFs within the reach of small investors.
A closer look shows these offerings have several strikes against them -- and are no more desirable than an account at a cut-rate online broker -- and considerably worse from a cost perspective than a good old-fashioned, low-cost open-ended index fund.
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Questionable strategies
The funds of ETFs are few, young, small, and managed by people who have little or no prior track record of running mutual funds. Their strategies also leave much to be desired. Take one-year-old PMFM ETF Portfolio Trust (ETFGX), for example. The fund, which has more than $200 million in assets, uses a computer model to help it select ETFs on the basis of technical measures, such as market breadth, trend lines, interest rates, and relative strength. It expects turnover of more than 100%, which could generate enough trading costs and capital gains to negate the expense and tax benefits of the ETFs it owns.
Then there is three-year-old Everest3 (EVCUX). It takes a much less frenetic, buy-and-hold approach. The offering distributes its money among three ETFs: SPDRs (SPY, news, msgs), which track the Standard & Poors 500 ($INX); Diamonds (DIA, news, msgs), which follow the Dow Jones Industrial Average ($INDU); and the Nasdaq 100 Index Tracking Stock (QQQ, news, msgs), which apes the Nasdaq 100 ($NDX.X). However, with about half of its money concentrated in giant-cap stocks and virtually none in smaller equities, this three-indexes-in-one fund is not really as diversified as it looks. Its track record is pretty poor, too. The fund, which shifts its asset allocation according to market conditions, has finished each of its three full years of existence below the large-blend category average.
High costs
But the real kicker is costs. Like most funds of funds, these offerings charge expense ratios on top of the levies of the underlying ETFs. The PMFM ETF Portfolio Trust's expenses are capped at 2.5%, but even a price tag less than half as big would be too much. You only have to look at Everest3's expense ratio for proof. The fund charges a reasonable-looking 0.75% per year (about average for funds of funds).
Still, according to Morningstar's Cost Analyzer, the total price of investing $5,000 in the Everest3 and making monthly contributions of $250 for 10 years is almost the same as spreading $5,000 equally across SPDRs, Diamonds, and Qubes at an ultra low-cost broker such as Sharebuilder or FOLIOfn (where you can get $4 trades) and following the same plan.
And the nearly $1,900 total cost of both of those schemes is more than three times the roughly $500 total costs of buying and dollar-cost-averaging into Vanguard Total Stock Market Index (VTSMX) over the same period.
Until funds of ETFs address these problems, we'd stay far away.
Copyright 2004. Morningstar, Inc. All rights reserved.
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