Throughout the wild markets of recent years, money has flowed into exchange-traded funds (ETFs); about $750 billion is now invested in ETFs in the U.S., that’s up by about 50 percent compared to a year ago. Proponents of ETFs claim that they offer an efficient way to manage portfolios. But advisors we know remain divided about ETFs. At one end of the spectrum, a growing number of advisors are putting all their assets in ETFs. At the other extreme are those who steer completely away from the funds. A third group shops selectively, using a mix of ETFs and conventional funds. Any approach can serve clients well—as long as advisors have a clear idea about the strengths and weaknesses of ETFs.

Among the ETF proponents is Kyle Chudom, a wealth advisor with Morgan Stanley Smith Barney, who is a member of a team that manages $400 million of ETF portfolios in Oakbrook, Illinois. Chudom gives a list of reasons for preferring ETFs. For starters, many ETFs have rock-bottom expense ratios. And since most track indexes, shareholders can know exactly what they own every day, an important consideration at a time when clients still worry about a repeat of the Madoff scandal.

For Chudom, ETFs also represent an efficient way to manage client portfolios. His company provides three model ETF portfolios, conservative, moderate-risk and growth. The advisors can use the portfolios as they are designed or customize them for individual clients. The model ETF portfolios can relieve advisors from the burden of generating investment ideas. “By relying on the model portfolios, you are free to spend lots of quality time with clients,” says Chudom.

Strategies
With more than 800 ETFs, investors can use them to precisely calibrate their portfolios, says Kim Arthur, president of Main Management, a registered investment advisor in San Francisco that clears trades through TD Ameritrade. Investors can use the funds to hold Asian real estate or U.S. oil equipment providers.

Arthur typically starts with some holdings that track broad measures, such as the S&P 500, and then spices up the portfolio by overweighting some sectors. Recently he emphasized technology by holding Technology Select Sector SPDR (XLK).

For the broad benchmarks, it is possible to use open-end index funds, but Arthur says that ETFs have some clear advantages. For example, some options trade on ETFs. So Arthur can buy SPDR S&P 500 ETF (SPY) and sell a covered call. No such options exist on open-end funds. “With options trading, we can generate income and get some downside protection,” says Arthur.

For all their advantages, ETFs are not always the best choices, says Richard Ferri, research director of Portfolio Solutions, a registered investment advisor in Troy, Michigan, that clears trades through Charles Schwab. After comparing ETFs and traditional funds, Ferri designs portfolios that include a mix of both types of investments. “I am looking for the funds that best represent asset classes,” says Ferri.

When sizing up an ETF, Ferri starts by examining the costs of trading the investment. Some ETFs can be expensive to use because they sell at hefty premiums or discounts to the values of their portfolios. This became all too clear during the market turmoil. After dipping to a discount in the fall of 2008, iShares Barclays Aggregate Bond (AGG), a mainstay of many portfolios, rose to a premium of 2.21 percent in December. Since then, the fund has traded at a premium, which recently dipped to 0.27 percent. So investors who bought in late 2008 could have paid $1.02 for assets that are currently worth a bit more than a dollar. In contrast, open-end funds always trade at the value of their assets.

Along with trading costs, Ferri also reviews the quality of the benchmark that the ETF tracks. Most ETFs are index funds, and some follow benchmarks with quirks that can distort returns. For example, in a typical bond ETF, the issuers with more debt carry more weight. So investors put more of their assets into heavily leveraged companies. That strategy suffered in 2008 when indebted companies sank.

Because of concerns about trading costs and the construction of the
benchmark, Ferri avoids ETFs that invest in high-yield bonds. Instead, he owns Vanguard High Yield Corporate (VWEHX), an actively managed fund that steers away from heavily indebted companies.

When Ferri buys ETFs, he typically takes the cheapest choices. For real estate exposure, Ferri uses Vanguard REIT Index ETF (VNQ) instead of the open-end Vanguard REIT Index (VGSIX). Both funds hold the same stocks, but the ETF has an expense ratio of 0.15 percent, compared to 0.26 percent for the open-end fund. Besides being cheap, the ETF is easy to trade, rarely selling for big premiums.

To invest in emerging markets, Ferri prefers DFA Emerging Markets Core Equity (DFCEX), an open-end fund that provides broad exposure to the sector with some emphasis on small and value stocks. To cover the same ground, an investor would need to hold a cumbersome group of several ETFs, says Ferri.

Enhanced by Securities
Some advisors prefer mixing ETFs with individual stocks and bonds. Jim Mullins, CEO of Mullins Wealth Advisors in Fort Worth, starts by putting about 60 percent of his portfolios in a core group of broad ETFs, including funds that track total market benchmarks. With about 30 percent of assets, he overweights his favorite industries using sector ETFs.

For 10 percent of his portfolio, Mullins typically shops for individual stocks. “When I see a stock that seems severely undervalued, I may buy it and hold on for the long term,” he says.

Mullins avoids open-end funds partly because they sometimes generate unexpected tax bills. This can occur when shareholders make withdrawals. To raise cash for redemptions, portfolio managers must sometimes sell holdings. When that happens, a fund may generate capital gains. Those are passed on to shareholders who can face bills at tax time. ETFs generally avoid the problem because they need not raise cash for redemptions; retail shareholders who want to dump their shares must sell them to other investors.
But bear in mind that some open-end funds may be more tax efficient these days. After suffering heavy losses during the recent bear market, the funds now have stockpiled capital losses. Those can help to shelter future gains, making the open-end funds the right choice for tax-conscious investors. Funds that have strong long-term records and sizable losses on the books include Eagle Mid Cap Stock (HMCAX) and Brandywine (BRWIX).