As exchange-traded funds (ETFs) have become increasingly popular and investors have discovered their benefits, financial services firms have developed more ways to package those benefits. Enter the ETF wrap, a packaging innovation that is beginning to gain attention. It offers all of the benefits typically associated with an index fund - and more. Here we'll look at the types of ETF wraps available, discuss their advantages and disadvantages, and see what the future holds for this relatively new financial product.

Account Types and Benefits
An ETF wrap is similar to a mutual fund wrap, except the underlying investments are ETFs. (If you are unfamiliar with ETFs or Mutual Fund Wraps, see Introduction to Exchange-Traded Funds and Introduction To Mutual Fund Wraps.) Like mutual fund wraps, ETF wraps are available in two varieties: discretionary and non-discretionary.

Discretionary Account
From an asset allocation perspective, discretionary accounts are similar to lifestyle funds. They offer a variety of pre-selected equity, balanced and fixed-income asset allocation models designed to suit the needs of a wide range of investors. These models typically reflect a range of potential portfolios from 100% equity to 100% fixed income, with balanced models generally varying from 80% equity/20% fixed income to 20% equity/80% fixed income. Professional money managers oversee the portfolios, selecting investments, monitoring performance and rebalancing to maintain the desired allocation. (To learn more about asset allocation, see Achieving Optimal Asset Allocation.)

Non-Discretionary Account
In a non-discretionary account, the investor is responsible for creating an asset allocation model, selecting ETFs to match the model, monitoring the portfolios and rebalancing as necessary (this can also be done with the help of an advisor).

Both discretionary and non-discretionary accounts provide access to a broad range of diversified investments. Investors can choose from ETFs that track indexes in an ever-growing range of sectors, countries and markets. All of the major indexes are covered, including the S&P 500, the Nasdaq and the Dow. There are also specialty ETFs that provide exposure to real estate, biotechnology, emerging markets and more. 

Better Than Mutual Fund Wraps
ETF wraps are gaining market share for a host of reasons, including the fact that they are generally much less expensive than comparable mutual fund portfolios. An article published by Dow Jones Newswires earlier this year, "ETFs Are Moving Into The Spotlight" by Tara Siegel Bernard, cited the expense ratio for the average domestic stock ETF at 36 basis points, compared with 88 basis points for the average domestic stock index fund. Yes, ETF wraps charge an additional layer of fees to cover trading, administration, and so forth, but so do mutual fund wrap programs. When the wrap fee is factored out, the cost difference comes down to the expense ratios of the underlying investments, and the ETFs really shine.

ETF wraps also have greater trading flexibility than their mutual fund cousins. Unlike mutual funds, which trade once per day, ETFs offer the flexibility of intraday trading. If the markets are rising or falling, investors can make real-time decisions regarding the disposition of their portfolios. While this may not be a significant advantage to longer-term ETF wrap investors, it can be a huge bonus for more active investors who constantly trade in and out of their ETF holdings.

On the tax efficiency front, ETFs are also superior to mutual funds. New investors do not inherit embedded capital gains, and large redemptions are handled with in-kind distributions of the underlying securities, so the bulk of an investor's capital gains tax liability is deferred until the investor sells his or her holdings. (See An Inside Look At ETF Construction for more information about ETFs and tax efficiency.)

A less tangible - but psychologically attractive - benefit of investing in ETFs (and, by association, ETF wraps) is the fact that ETFs remain untainted by the scandals that have affected the financial services industry in general and the mutual fund companies in particular. Adding to this psychological comfort level is the inherent transparency of ETF portfolios - investors always know exactly what is in the portfolio. This is not the case with mutual funds, which only report holdings on a periodic basis.

Cost Factor
If there's a downside to ETF wraps, it comes in the form of trading costs. Since ETFs trade like securities, there generally is a commission associated with each trade. This cost factor makes ETFs a less attractive investment vehicle when it comes to dollar-cost averaging. (For more information, see Dollar-Cost Averaging With ETFs.)

However, where there is a problem, there is always somebody working on a solution. Some firms are exploring ways around the obstacle presented by commissions by offering ETF wrap accounts in a commission-free environment. Others offer commissions that are less than $5 per trade. Both options enable investors to add additional funds to an existing account without paying unreasonable fees.

Conclusion
Although ETF wraps are still relatively new additions to the family of managed money products available to investors, they are already making their mark on the investment landscape. (To find out more about other managed money offerings, see Wrap It Up: The Vocabulary and Benefits of Managed Money.) Pension plan sponsors and individual investors have both recognized the intrinsic appeal of ETF wraps. The pension plan sponsors are attracted to the pre-selected asset allocation models and expense ratios that are lower than most mutual funds. The individual investors enjoy those features too and view the ability to trade intraday as an added benefit. Only time will tell for sure, but if early indications are any predictor of future success, ETF wraps seem destined to attract more attention and more investors.
 

by James E. McWhinney, (Contact Author | Biography)

James McWhinney has been a professional writer for nearly two decades. He has worked for many of the nation's top mutual fund providers and banks in addition to numerous magazines, websites and other publications. He specializes in financial services and travel.