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Fund Spy

Funds of ETFs Leave Much to Be Desired

High costs hinder the appeal of these funds of funds.

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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.

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.