Funds of ETFs are the latest craze.

    If one is good, two (or five) must be better, right?
With the surging interest in exchange-traded funds (ETFs), it was only a matter of time until someone decided to package them together into a fund-of-funds structure. After all, "funds of funds" are big business, attracting billions of dollars in investments each year. Add in the low-costs and targeted exposure of ETFs, and you should have a hit.

At least, that's the thinking behind a rush of interest in the "funds of ETFs" space. As an ETF reporter, my e-mail box is full to overflowing with pitches from developers of these new products, trumpeting them as smart, "one-stop-shopping" solutions to all the problems vexing today's individual investor. If the developers have anything to say about it, "funds of ETFs" and other ETF portfolio solutions are likely to emerge as one of the major stories of 2007.

But do these products really make sense? Do they provide a service for investors? With the fee structure of some of these fund of ETF products, you've got to wonder if many investors wouldn't be better served to find their portfolio diversification elsewhere, says Jim Wiandt, editor of the Journal of Indexes.

Tom Murphy, owner of TEMAA Financial in Dallas, says his stance on a fund-of-fund solution would depend on whether they retain the chief benefits of ETF investing-low fees and tax efficiency. "If they can get some excess return in the ETF, and remain more tax efficient, then that might be worth" some additional expenses, he says.

Matthew J. Murphy, president of Murphy Capital Advisors in Buckeye, Ariz., is skeptical of paying for someone to package ETFs when he could do the job himself. "All they are really doing is adding an extra layer of fees," says Murphy, which uses ETF products for about 70% of his client portfolio assets.

The Contenders: Mutual Funds

First, it pays to know the field. There are currently two avenues of development in the "funds of ETFs" space.

On the one hand, you have advisory companies and mutual funds that are packaging ETFs into alternative product structures. One example is XTF Advisors, a traditional advisory firm that has decided to focus its energy exclusively on ETFs. The group packages ETFs in a variety of ways-separately managed accounts, open-end funds, unit investment trusts-creating portfolios of ETFs the way you might create a portfolio of individual stocks.

XTF, operating since 2000, has built its business by offering two basic flavors of funds: "Target Maturity" funds designed to fit the needs of investors of different ages, and "Tactical ETF" portfolios that adopt different levels of risk (reflected in different ratios of equity vs. fixed-income exposure). Earlier this year, they also launched sector- and country-rotation portfolios, which use quantitative strategies to move assets to those areas of the market XTF believes are best positioned to outperform.

These products are certainly interesting, because they're offering a sensible, targeted allocation that might not otherwise be available to many investors, and they are doing it at what some consider a reasonable cost.

That's really the rub: how reasonable is the cost? XTF is in the process of launching open-end mutual funds tied to its strategies. For these funds, XTF will layer a 50-basis-point advisory fee on top of the fees charged by the different ETFs. For instance, for its Target Date portfolios, XTF will charge a 50-basis-point advisory fee in addition to the 18 basis points levied by the underlying ETFs. There also will be additional fees of 15 basis points, reflecting trading costs and other charges. In other words, investors will pay nearly 1% per year to hold a group of ETFs that charge just 18 basis points.

That may seem like a lot, but compared to some offerings on the market these funds of ETFs can seem like a bargain. At the other end of the spectrum are groups like Arrow Investment Advisors, who utilize ETFs to execute active investment strategies. Arrow's flagship fund is the Arrow DWA Balanced Fund (DWAFX), a fund-of-ETFs that relies on a relative strength strategy to pick and choose different ETFs as asset classes come in and out of style.

In addition to loads and other charges, DWAFX levies a 1.75% expense ratio before you factor in the expenses for the underlying ETFs. According to the most recent prospectus, those ETF expenses would add an additional 39 basis points to the total fee. Fortunately, Arrow caps expenses at 2% for the strategy. But still, paying 2% to hold a family of ETFs that charge 39 basis points is a far cry from the low-expense strategy most people associate with ETFs.

True EoEs

The next big leap will come soon: true "ETFs of ETFs," or EoEs. There are not currently any EoEs in registration, much less on the market, but there are a number of companies looking at the space. Although these companies are keeping a low profile for now (all refused to comment publicly for this story), we are certain to see the first EoE filing by the end of the year. Companies are generally pursuing two approaches: tactical asset allocation strategies that shift exposure between different sectors or asset types based on market trends, and straight asset allocation funds that combine different assets into a one-stop-shopping experience. The challenge for the latter is to keep fees low enough to make the rebalancing benefits worth the extra costs; if they can do that, the asset allocation EoEs could be a hit.

Do They Make Sense?

The question of whether these products make sense is really two-fold. First, you have to ask whether funds-of-funds make sense. And then you have to ask whether ETFs are better or worse instruments than traditional active funds for the fund-of-fund structure.

The first question is really beyond the scope of this article. Funds-of-funds is a popular product structure, and they come with advantages and disadvantages. On the plus side, they offer instant diversification and a regular rebalancing schedule-both of which are unmitigated goods for a smart investment portfolio. On the flipside, they layer fees on top of fees, taking a low-cost strategy and often multiplying its expense ratio many times. XTF Advisors, remember, plans to charge approximately 1% per year for a package of ETFs that cost just 18 basis points on their own. It's up to the individual advisor or investor to determine whether the additional 82 basis points is a fair price to pay for the rebalancing schedule, although it seems like a smart advisor could execute the same strategy for most clients at a lower cost.

These new products also come at a time when advisors are being inundated with new ETF products on almost a daily basis. "When you see everybody and their dog has a new shell out there, I'm a little skeptical," says Penny Marlin of Marlin Financial in Delray Beach, Fla.

Although Marlin feels a fund-of-fund structure for ETFs could potentially bring benefits, she plans to wait until the products build up a track record before considering them for her clients.

Marlin, however, feels the 1.75% expense ratio of the Arrow DWA Balanced Fund is too high, and questions what the tax impact will be of the fund's active management strategy. Murphy of TEMMA Financial agreed, saying, "That would be way too expensive. It would be very hard to get the excess return to overcome that kind of expense ratio."

There is also a clear drawback to funds of funds when it comes to tax efficiency, says Murphy of Murphy Capital Advisors. If individual ETFs within a packaged product finish the year at a loss, the fund-of-fund structure prevents him from doing tax loss harvesting. "You are actually at a disadvantage," he says.

The other half of the question-whether ETFs are a better or worse tool than active mutual funds-has an easy answer: They are, without question, better.

The chief advantages of ETFs apply directly to the fund-of-funds structure. For one, they tend to be low-cost. So while a fund-of-ETF structure will still layer fees upon fees, it will at least layer fee upon smaller fees.

More importantly, however, is the fact that ETFs do what they say. Unlike active funds, which often suffer from style drift as managers follow whatever's hot, ETFs hold a publicly disclosed portfolio that doesn't waver or shift; you know what you're getting. For an asset allocation strategy, that's gold.

When you factor in the tax benefits, the choice is clear: ETFs win.

Conclusion

The big picture story, however, is mixed. Like all funds-of-funds, funds of ETFs layer fees upon fees, detracting from long-term returns. In many cases, they follow a simple strategy that a smart advisor could execute at lower cost.

But for some investors, they provide an easy way to achieve a desired exposure, and add in a low-cost and regular rebalancing schedule that studies show improves long-term returns. Beyond question, they make better components for a fund-of-funds structure than actively managed mutual funds. By eliminating style drift and keeping expenses low, ETFs-of-ETFs mitigate the sharpest criticisms of fund-of-fund structures. If you're using a fund-of-fund structure, it might be time to switch.

- Senior Editor Raymond Fazzi contributed to this story.