On the face of it, the combination seems counterintuitive. On one hand, you have professional financial advisors looking for a way to “add value” and justify fees that can range as high as 2 percent of assets. On the other, you have an emerging class of index-based products that promise lower costs and fewer tax headaches than clients get with actively managed mutual funds.

But to a new crop of vendors, this unlikely marriage — separately managed accounts composed of exchange-traded index funds — looks like a winner: Clients pay for the asset-allocation advice, but then also get the low costs they seek for asset management. So, separately managed accounts that invest exclusively in exchange-traded funds are vying for a place at the advisory table, as an increasing number of money managers look to cash in on the popularity of these very cheap, very liquid investments.

“This is one of the fastest-growing segments out there,” says Gary Gastineau, principal of ETF Consultants in Summit, N.J., and author of the book The Exchange-Traded Funds Manual (Wiley, 2002). “It's growing a lot faster than SMAs of individual stocks.”

While it's difficult to quantify the number of firms running ETF SMAs, a number of new entrants has sprouted up in recent months. IXIS Asset Management Advisors of Boston, a subsidiary of IXIS Asset Management Group, one of the largest money managers in the world. with $496 billion in assets, recently rolled out its Active Managed ETF Portfolios (MEPs). They invest solely in ETFs at a lower minimum and significantly lower fees over time than equity SMAs, the company says. In addition, there is Amerivest Investment Management, an advisory subsidiary of Ameritrade.

ETF assets have more than doubled to $251 billion as of Aug. 31, up from $119 billion in September 2003, according to the Investment Company Institute. The bulk of the inflows — more than 80 percent — have come from institutions and not retail investors.

It's the Asset Allocation, Stupid

ETFs are so popular because of the cost: The average ETF sports an expense ratio of 0.43 percent, cheaper than both the average open-end mutual fund (1.38 percent expense ratio) and index fund (0.83 percent expense ratio), according to Morningstar. In addition, ETFs trade on exchanges like individual stocks and offer broad diversification. In fact, if you believe asset allocation and not individual stock selection is a key driver of performance, then ETFs seem ideal. Former investment manager Gary Brinson built an asset management empire (since bought by UBS) based on his research, which showed that roughly 95 percent of performance is derived from the asset class and not from the individual security selected. (ETFs come in many flavors, from large-cap to small, from growth to value; they also represent many individual economic sectors and even commodities, fixed income and real estate.)

“Given the rise in index funds and the conflicts of interest that have been uncovered with brokers pushing mutual funds in return for a share of the asset-based fees, ETFs make a lot of sense for brokers,” says David Jackson, editor of ETFInvestor.com, a blog that tracks ETFs. “The broker switches to an asset-based fee model and then chooses the cheapest, most efficient product for the client. In most cases, that will be ETFs.”

SMA wrappers are a convenient way to create custom ETF-based portfolios. XTF Advisors of New York, for example, unveiled a new ETF-only SMA product in September, one that includes three portfolios designed to exceed the returns of passive index strategies by 1.6 percent annually using a tactical asset-allocation model. Financial advisors can choose from an aggressive, moderate or conservative portfolio that typically holds eight to 10 ETFs at a time. A minimum investment of $50,000 is required, but that's far lower than many traditional SMAs, which often require at least $250,000 for adequate diversification. XTF's portfolios are available on CheckFree's platform.

The concept of actively managing what has been regarded as a passive investment vehicle may seem a little confusing. But, it shouldn't, says Jeff Keil, principal at Keil Fiduciary Strategies, a consulting firm in Littleton, Colo. “You're paying for asset allocation. You're getting low-cost market tracking with a hint of active management.”

According to Tom Mench, a pioneer in ETF-based separate accounts, that's good enough to get some interest from traditional brokers. “The major wirehouses are warming up to the ETF SMA,” says Mench, CEO of Mench Financial, a registered investment advisor in Cincinnati, which runs five ETF-only SMAs. Mench's products are available through the top five wirehouse platforms, but are not on their recommended lists. “An ETF-based SMA offers the fewest number of securities with maximum diversification, reduced number of transactions and costs and, in our case, adds value over and above a relevant benchmark,” Mench says.

Jeff Holland, vice president of Raymond James Consulting in St. Petersburg, Fla., is not a big fan, however. “It's not clear to me what the value proposition is,” he says. “I think they're trying to hop on the latest gimmick.” He also wonders if ETF SMA managers are essentially market-timers who will jump from one sector or style to chase returns. “I'm extremely skeptical of people trying to time the market,” he says.

But the fact is: ETFs are relatively cheap securities that offer broad diversification. For advisors who chafe at the expense of actively managed funds, and for those who believe it's easier to pick hot sectors than hot stocks (or hot managers, for that matter), ETFs represent a strong foundation upon which to build a portfolio.

Unlikely Hybrid Struts Its Stuff

Percentage returns, net of fees, for Mench's Global Sector Enhanced portfolio, an ETF-based SMA, relative to key benchmarks.

1-Year 3-Year 5-Year Inception
Mench Global Sector Enhanced 12.17% 10.66% 4.01% 8.79%
Morgan Stanley World Index 10.60 10.57 -1.65 6.04
S&P 500 Total Return Index 6.30 8.27 2.38 8.15
Period Ending June 30, 2005
Source: Mench Financial Inc.