Mutual Funds That Bank on ETFs

Why the ETF Market Opportunities Fund invests solely in exchange-traded funds

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Exchange-traded funds are not only making headway with investors; some mutual fund managers are embracing them as a way to spread their portfolios among different asset classes. "With the rise of ETFs as an asset class, it has made it much easier for institutions to hold broad baskets of securities, entire sectors, entire industries, or even entire asset classes," says Bradley Kay, ETF analyst for Morningstar. Some managers are beginning to use a single broad-based ETF that covers an index like the S&P 500 as an alternative to cash. "It's another way to avoid cash drag if you're having a generally positive outlook on the market but you're having trouble finding great outperformance ideas," Kay says. These days, more than 70 mutual funds hold ETFs that make up at least 50 percent of their total assets, according to Morningstar.

[See the 10 Strangest Mutual Funds.]

Paul Frank manages the ETF Market Opportunities Fund (ETFOX), a mutual fund made up entirely of underlying ETFs. Before the fund's 2004 launch, Frank had managed funds that held shares of other mutual funds. He's giving ETFs a shot now. So far this year, the fund has returned about 29 percent. U.S. News recently spoke with Frank about investing in ETFs. Edited excerpts:

Explain your fund's investing strategy.

Usually, between 75 to 80 percent of the fund is invested in U.S. equities. Right now, we're overweighted in mid-caps. The other 20 to 25 percent of the fund is where a lot of the number-crunching comes in, and what I'm trying to do is lower the volatility of the fund. I'm looking for things that aren't correlated that are performing well. I look at 800 or so ETFs out there, and I try to whittle it down to about 200, which is a more manageable size. I throw a lot out that I have no interest in or that are tiny. Then I do two Sharpe ratios. The Sharpe ratio is return over volatility. I do it for two different time periods—a long time period and a short time period—and I'm constantly plotting that. What I'm trying to find is the ETFs that are popping, where their Sharpe ratio is spiking up.

[The fund is] usually going to hold between a dozen or two dozen [ETFs]. . . . I'll own silver. We've owned silver this year. We owned a tiny bit of gold. We've mainly tried to play that through silver and then some international stuff. We've owned [iShares MSCI Hong Kong Index ETF] for most of the year, and we also recently added [Market Vectors Indonesia ETF]. . . . Out of all the ETFs that cover the Asia region, it's the least correlated to the S&P.

What does it say about the popularity of ETFs that some mutual funds are investing entirely in ETFs?

They are popular, and they're still the smaller cousin, but they're growing. Last year, mutual funds saw outflows. I'm a mutual fund. I know about it. ETFs did not [see outflows] last year. But the growth is right back up from last year, and it's like last year never really happened. . . . Are active ETFs going to fly? They may, but I just think when people buy ETFs, the nice thing about it is if you own the S&P 500 ETF and the S&P is up 1.1 percent that day, you know your ETF is going to be up 1.1 percent that day.