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DEFINITION of 'ETF of ETFs'

An ETF of ETFs is an exchange-traded fund (ETF) that tracks other ETFs rather than an underlying stock, bond, or index. Like a fund of funds, this new approach provides investors with a method to invest in multiple different strategies with one product. It combines the cost and transparency advantages of the traditional ETF structure with the research and analysis of an actively managed fund. Many well-established providers like Vanguard and Direxion have hopped on the bandwagon through new product offerings that combine different asset classes or rotate between sectors.

BREAKING DOWN 'ETF of ETFs'

An ETF of ETFs is a tool that provides more diversification than a regular ETF. They can be constructed on certain desirable factors such as risk levels, time horizons or sectors. One of these financial instruments can give an investor broad exposure to many sectors and asset classes. On average, ETFs have lower fee structures whereas a managed fund tends to involve more research and analysis. An ETF of ETFs aims to strike a delicate balance between the two and beat a standard benchmark index. 

The concept of an ETF of ETFs finds its roots in traditional target-date and other asset allocation funds that seek to provide simple investment solutions. An investment in a quality multi strategy fund is appropriate for novice investors who lack the skill or resources to construct an attractive portfolio in the current environment.

The advantages don't end there. This novel approach affords investors instant diversification, low fees, and exposure to broad based strategies across different asset classes. In the event of a downturn, In the event of a downturn, a well diversified portfolio employing various strategies can help keep losses to a minimum.

Limitations of ETF of ETFs

While many of the newest ETF of ETFs claim to simplify investing, they often employ complex mechanisms that make it difficult to understand the various offerings in the fund. What's more, the products are often highly concentrated and tend to exhibit greater turnover than most actively managed funds. That means if the market turns against the fund, it could quickly become the largest holder of a thinly traded ETF.

A more straightforward – and cheaper – approach involves constructing a portfolio of individual stock and bond ETFs. Moreover, investors must rely on the skill of the portfolio manager to make critical asset allocation and tactically adjust the portfolio on a timely basis. Most empirical research finds a hands-off, buy and hold approach tends to outperform a stock picking strategy.

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