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.
"Financial advisors are using index-based ETFs to outperform with asset-allocation decisions," said Rob Nestor, head of iShares Smart Beta and Fixed Income Strategy at BlackRock. "Adoption has accelerated over the last two years, particularly in the fixed-income space."
Advisors have been slower to make use of passively managed index funds in the bond market than they have in equities, but that is now changing. Many still feel that riskier sectors such as municipal and high-yield bonds still require an active hand, but in the Treasury and investment-grade markets, ETFs are rapidly gaining market share. "In a market with lower returns, lower expenses are all the more important," said Yeske at Yeske Buie.
While Yeske's surveys of advisors for the FPA have not delved deeply into how advisors are using fixed-income ETFs, he said the proportion of respondents investing in individual bonds continues to fall, suggesting that funds, particularly low-cost ETFs, are growing in popularity.
Wescott's Rawdin said persistently low interest rates have made bond laddering (where bond durations are staggered) less attractive. "There are not many rungs on that ladder, and there haven't been for some time," he said. "The bond funds are very competitive with their expense ratios."
Nestor at BlackRock also sees rapidly growing demand from advisors for smart beta funds and factor ETFs. Like the DFA model, the funds are passively managed according to rules that emphasize a desirable characteristic such as low valuation or low volatility. The funds are more expensive than simple index funds, and some feel that advisors are not using them intelligently. "A lot of advisors are loading too many of these things into portfolios because they make for a good story with clients," said Rawdin at Wescott.
Nestor, however, believes that demand for smart beta will continue to grow in the advisor community. "Advisors are still figuring out factor investing and how to use it, but adoption is accelerating," he said. Nestor spends a lot of time with advisors and their firms to understand the challenges they have with clients and with investment management.
"We try to figure out what kind of gaps they have in their tool kit, and that feeds our product development," he said.
That means that ETF shelf space will continue to expand, and so will the popularity of the funds with financial advisors.
— By Andrew Osterland, special to CNBC.com