Once indifferent, advisors hop onto ETF bandwagon

When exchange-traded funds crept onto the investing scene in the early 1990s, not many financial advisors paid attention.

In recent years, however, ETFs have become a linchpin for advisors, many of whom are relying almost entirely on these rapidly-growing products when putting together their clients' portfolios.

George Gagliardi, a certified financial planner with Coromandel Wealth Management, is in this camp.

"When I first started working in this business, ETFs were just getting popular," he said. "They made sense to me in terms of being the best building blocks available.

"They were more tax efficient, transparent and less expensive than most open-ended index funds," he added. "They also had a variety of options that has continued to increase."

Since then, Gagliardi has continued to use mostly ETFs in his clients' portfolios. He isn't alone.

According to a 2015 study by the Journal of Financial Planning and the FPA Research and Practice Institute, advisor use of ETFs has more than doubled over the last 10 years.

In 2015, 81 percent of advisors said they used or recommended ETFs to their clients, up from just 40 percent in 2006. That is likely to continue rising, as 51 percent of advisors said they were planning to increase their use or recommendation for ETFs with clients over the next 12 months.

Rose Swanger, a CFP with Advise Finance, said the flexibility of ETFs is a big draw and has prompted her to use them almost exclusively with her clients.

"I use ETFs 98 percent of the time in my clients' portfolio," she said. "The biggest benefit is the flexibility of trading.

"My clients don't feel like sitting ducks," she added. "If the market drops, they don't want to have to wait until 4 o'clock to sell a mutual fund. ETFs avoid that problem." Swanger also likes that ETFs offer the ability to use stop loss and limit orders, which mutual funds don't offer.

Like many advisors, Swanger uses traditional, broad-based ETFs for the core of her clients' portfolios. She then includes smaller positions in various sector ETFs that she buys when the opportunity presents itself.

The goal of her strategy is to achieve high growth or dividend potential, depending on her clients' needs. By using ETFs in this way, she said, "you're not just passive investing — you're actively managing a portfolio for the best interests of the clients."

Gagliardi, at Coromandel Wealth Management, uses ETFs in a similar manner, starting with a few core holdings to get exposure to U.S. and non-U.S. large caps and then supplementing with various ETFs that offer exposure to certain sectors, countries and commodities. He also uses actively managed bond and currency-hedged ETFs.

Although ETFs are most prevalent in Gagliardi's clients' portfolios, in cases of less-liquid markets that aren't as well researched — such as muni bonds, high-yield bonds or emerging markets debt — he often opts to pay more to have an active manager at the helm.

Despite the fact that there are more than 1,600 ETFs on the market, offering exposure to pretty much every nook and cranny of the investment landscape, advisors tend to favor the same group of products.

According to Tom Lydon, president of Global Trends Investments and editor of website ETFtrends.com, out of the $2 trillion in U.S. ETF assets, more than half is concentrated in the top 100 ETFs. And most of that money, he said, is in the pure, traditional index-based products.

However, Lydon added, in the last five years, that's started to change as a "smart-beta evolution has begun to take hold."

Smart-beta ETFs, also referred to as factor-based ETFs, are based on indices that select and weigh securities based on one or a combination of factors. The factor can be anything from dividend growth or value to low volatility or stock buybacks.

The goal with smart-beta ETFs is to produce better risk-adjusted returns than you would achieve with a comparable ETF based on a traditional market cap–weighted index.

Smart-beta ETFs are catching on because, Lydon said, "advisors are seeing that by using single- and multifactor strategies, you can get a more intelligent index."

Smart-beta ETFs have garnered a lot of attention over the last few years, and while they have become more popular with advisors, they still have room to grow. In 2015, 22 percent of advisors reported using smart-beta ETFs with their clients, with 14 percent saying their use of the products had increased in the last 12 months.

In addition to upping their use of smart-beta ETFs, Lydon said, advisors have also increasingly been using ETFs for tactical strategies, particularly over the last 12 months.

For instance, he said that advisors have been using ETFs to make bets on commodities, especially in the metals and mining space. They have also been putting more money into emerging markets, where there are some good valuations to be found, particularly with certain country ETFs.

Additionally, in the bond ETF space, Lydon noted, advisors have been moving toward high-yield ETFs, largely because they are trading at such steep discounts due to their significant allocation to energy-related companies.

Lydon attributes this increased use of ETFs for tactical purposes to a heightened understanding of the products out there.

Several years ago "advisors weren't as comfortable with ETFs or may not have had the research capabilities," Lydon said. "Now they are very much aligned with what ETFs can offer."

He added, "They've implemented research, and they're more comfortable with the liquidity. ETFs are already a big core position in many advisor portfolios. And now were seeing a greater demand for using ETFs for tactical strategy."

Another way advisors are increasingly using ETFs is by purchasing ETF-based models through third-party ETF strategist or ETF investment managers.

This business, which Lydon said is growing at 40 percent per year, can be very beneficial to a lot of advisors who may be on board with ETFs but are looking for help in managing their portfolio and implementing tactical strategies.

— By Jennifer Woods, special to CNBC.com