We will end our look at exchange traded funds (ETFs) with a few words on fund of funds.
Fund of funds are also available with mutual funds, so my comments equally apply to them.
I am not keen on fund of funds, so I shall keep this brief.
Fund of Funds
As the name indicates, an investor purchases an ETF (or mutual fund) whose holdings consist solely of investments in other ETFs (or mutual funds).
In this sense, it is the same as life cycle ETFs. However, fund of funds maintain their stated asset allocations, they do not adjust the mix over time.
For example, consider the iShares S&P Growth Allocation Fund  or the PowerShares RiverFront Tactical Balanced Growth Portfolio . I have linked to each so that you may see the asset allocations, portfolio holdings of other ETFs, and expense ratios.
I think simplicity is the primary advantage.
You do not need to buy multiple investments in order to create a diversified portfolio. You simply purchase one that matches your desired asset allocation. Further, the fund of funds automatically adjusts its holdings to maintain the stated mix. Instead of monitoring and assessing many investments, you only need to track the one ETF.
Relative Cost Effective Diversity
Secondly, because fund of funds invest in other ETFs, the holdings are relatively cost effective and efficient investments. Relative, that is, compared to active management strategies or holding mutual funds.
Plenty of Options
Thirdly, there are a wide variety of fund of funds available. You should be able to find one that meets your specific investment objectives. Whether that be a simple split between cash, fixed income, and equities, or something more complex.
For me, the deal breaker with fund of funds is always the incremental cost involved. That is why I am not a fan.
A major advantage of ETFs, in general, is their relatively low total expense ratios.
But, as at December 2010, with either the iShares or PowerShares ETFs you pay an annual management fee of 0.25%. That is on top of all the expenses you pay for in the underlying ETFs that the fund holds.
All expenses factored in, the iShares costs should be approximately 0.46% although the asset manager, BlackRock, has agreed to waive 0.14% of their management fee until June 30, 2012. PowerShares lists an annual all in total expense ratio of 0.64%.
We seem to be moving away from our previous analysis of low cost ETFs with 0.09% total expense ratios . A long way.
Potential Double Dipping
Potentially adding insult to injury are the fund of fund’s holdings.
If you look at the holdings of iShares fund of funds, you will see that it invests in other iShares’ ETFs. The same with PowerShares. Its fund of funds invests primarily in PowerShares’ ETFs.
This can potentially mean the double dipping on certain expenses charged to fund investors.
Potentially Not the Best Investments
It can also mean that the fund is not investing in the best available ETFs. Rather, the prime criteria for ETF selection is the issuer of the individual ETF.
There are differences in performance and costs between different ETFs within the same category. I would rather select the best available ETF in a specific asset class, not simply choose the ETF because it is from the same company as the fund of funds.
You might make an argument that it is worthwhile to pay management fees for life cycle ETFs. Yes, they are still fund of funds, but at least the asset manager is playing some active role.
You might also make a case for actively managed ETFs that invest in other funds.
I do not think manager efforts justify the costs in either case, but I can see where others believe differently.
But with fund of funds, the only management is in buying the ETFs and maintaining the proper stated balance.
That is something that most investors can do on their own with very little work. If you want to pay someone to do it for you, fine. But it is crucial for investing success to minimize your costs in order to maximize your compound returns over the long run.
I do not expect you to become an investment expert and spend countless hours poring over data. However, setting up and maintaining a suitable asset allocation mix using ETFs and low cost mutual funds is not difficult. I suggest you spend the time to invest in individual ETFs or mutual funds on your own and not pay someone else.