Fee-based financial advisors have been among the more enthusiastic users of low-cost exchange-traded funds for years, but their interest has dramatically increased since the financial crisis.
The latest survey of advisors conducted by the Financial Planning Association found that 88 percent of those surveyed now use ETFs, compared to 40 percent in 2006. Eighty percent said they use mutual funds in their practices, as well.
“The proportion of advisors using ETFs more than doubled in the last decade,” said David Yeske, head of registered investment advisor Yeske Buie and practitioner editor of the FPA’s Journal of Financial Planning. “ETFs now represent the biggest investment category for advisors.”
The reasons are simple enough: low costs and broad diversification. The vast majority of ETFs passively track an index of securities and typically charge lower fees than actively traded funds in the same investment categories. Not all ETFs cost less than mutual funds — particularly indexed mutual funds — but most are substantially less expensive.
For fee-based advisors, investment costs are important, and ETFs have helped drive those costs down.
“The earliest advisors to use ETFs set up low-cost buy-and-hold portfolios,” said Jim Rowley, senior strategist in the Investment Strategy Group at Vanguard, the second-largest provider of ETFs. “Active [fund] management risk isn’t a good or bad thing, but a lot of advisors don’t want to have the additional layer of active manager risk.”
Indeed, analyzing and selecting active fund managers is a major effort for advisors. A significant majority of active managers underperform their index benchmarks after fees, and picking the outperformers takes time and money.
“Using active managers is not easy,” said Grant Rawdin, CEO of Wescott Financial Advisory Group. “It requires a lot of due diligence.
“Advisors without a lot of resources or expertise are probably better off using a passive approach to asset management.”
Rawdin devotes a lot of effort to assessing active managers. However, he has about 40 percent of client assets in passively managed funds at Dimensional Fund Advisors. Not strictly a passive fund manager, the pioneer in factor investing now manages more than $500 billion in assets and is a favorite platform for many advisors.
Rather than tracking a market-cap weighted index, DFA screens a universe of securities and selects investments based on factors other than market capitalization, such as company size, fundamental quality, valuation or price momentum. “Their model is based on quantitative principles and ideas like small-cap stocks are better than large-cap, and value stocks are better than growth,” said Rawdin.
While Rawdin uses ETFs sparingly, many advisors have embraced them wholeheartedly. Increasingly, advisors are looking to add value not through security selection but at the asset-allocation level, where they actively manage passive products. With the development of thousands of ETFs offering exposure to broad markets (foreign and domestic), narrow market segments, industry sectors and virtually every asset class imaginable, advisors now have a very big shelf to choose from.