Robert A. Di Ieso, Jr.
By Sarah Max
September 28, 2015

Q: Part of my 401(k) is invested in a mutual fund in which two of the top ten holdings are ETFs. And one of those ETFs I already own separately in my retirement plan. It it normal for an actively managed fund to own ETFs? — Charles, Alabama

A: There are some legitimate — and not so legitimate — reasons why a mutual fund would put exchange-traded funds (ETFs) to work inside its portfolio. “It’s fairly common, though the reasons can be pretty different,” says Russel Kinnel, director of mutual fund research at Morningstar.

Increasingly, fund managers are using ETFs as cash management tools.

Most managers need to hold some cash to meet redemptions and make opportunistic investments. But too much cash — especially at today’s rates — can be a drag on returns.

As an alternative, more and more managers are parking some money in an ETF pegged to the fund’s benchmark index. This lets them stay close to fully invested but in a vehicle that is inexpensive, diversified, and liquid — more liquid than an individual stock.

“Managers are using ETFs the same way that 10 years ago they might have used futures,” says Kinnel, noting that this strategy is legitimate.

ETFs are also used by managers of asset-allocation funds, which are designed to offer one-stop-shopping for investors based on target dates or risk tolerance. Managers of these funds have traditionally used mutual funds, but more and more managers are executing their strategies with ETFs, again for valid reasons.

Still other managers use ETFs for tactical purposes — they want cheap, diversified, and liquid exposure to specific sectors or regions without having to bet on individual stocks.

For example, a diversified U.S. stock fund manager might think that biotechnology offers growth opportunity but, understandably, may want to spread the risk across many names. A global fund manager might like the prospects of, say, India but may decide that it’s more prudent to own the entire market than just a handful of companies.

“There are funds out there that may be making sector rotations and macro bets, in which case ETFs may be central to their strategy,” says Kinnel. As long as the logic behind the decision is clear — and it doesn’t send costs through the roof — it shouldn’t be cause for concern, he says.

When should an ETF be a red flag?

If the choice of ETF seems to be at odds with the fund’s strategy and isn’t for cash-management purposes. This is particularly true if you’re paying an active manager for his superior stock-picking skills or specialized expertise.

Meanwhile, it’s always a good idea to understand what’s in your funds and how those holdings compliment or, conversely, overlap with other investments.

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