Articles on exchange-traded funds proliferate in the mainstream and financial services industry media. ETFs were once of interest only to institutional and do-it-yourself investors, but I am increasingly noticing financial advisors using ETFs in client portfolios, although they’re still in the minority. Before jumping headfirst into ETFs, consider a few key points.

> Vanishing Fee Advantage. Most ETFs are effectively index funds. Canadian ETF fees start at 0.15% a year but average closer to 0.4% per year. U.S. ETFs can be had for less than 0.1% per annum. Canadian mutual funds sport an average management expense ratio of about 2% per year.

Accordingly, ETFs’ main advantage is a low MER. But these fees aren’t directly comparable. Most mutual fund fees include compensation for financial advisors while ETF fees do not. (Toronto-based Claymore Investment Inc. ‘s advisor series being the one exception.)

Advisors using ETFs typically put them in fee-based accounts in which clients pay a percentage fee in addition to ETF and fund MERs. A typical advisory fee is 1% (plus taxes), and I’ve seen many fee schedules start at 1.4% (plus taxes) on the first $250,000 or so. Advisors using ETFs in fee-based accounts are effectively shifting much of passive investing’s cost advantage into their own pockets.

The above advisory fees would bring total client fees into the range of 1.5%-1.9% per year. At 2% annually, mutual fund investor costs (which usually include advice fees) come in only slightly higher. The benefits of using ETFs become more questionable as total client fees approach mutual fund fees.

Such an approach is more transparent but not necessarily cheaper.

> Compliance Concerns. Advisors charging an advisory fee on top of the fees charged by ETFs could run into a couple of potential compliance concerns.

First, compliance departments may scrutinize advisors using the standard arguments of indexing if virtually all of the strategy’s main appeal — its cost advantage — is eaten up by advisory fees.

Second, using ETFs instead of mutual funds can result in higher annual advisor compensation. For a balanced mutual fund portfolio, trailer fees range from 0.5% per year for bond funds to 1% for stock funds. Balanced funds fall in between, at about 0.75% per year. But advisors charging even 1% annually on an all-equity ETF may find themselves taking a bigger fee compared to that offered by mutual fund compensation.

I would expect additional compliance scrutiny whenever advisors choose an option that pays them a higher annual fee. (Many wrap programs fall into this boat, as many pay advisors 1% annually regardless of the asset mix.)

> Outperformance And Value-Added. ETF proponents argue that using an ETF will result in a better return than that of the “average” mutual fund (after fees) in the same asset class. This is generally a sound argument but is usually made in the “index vs. funds” context. Such arguments do not take into account the typical 1% (or higher) fee that advisors add on for fee-based accounts.

And there is another consideration. Performance comparisons usually focus on raw returns. For most clients, risk-adjusted performance is more important than raw returns. I would consider an actively-managed portfolio to have added value if its performance can match or approach that of a passive portfolio, but with materially less risk or volatility. My quantitative research on investor behaviour over the past dozen years suggests that the higher the volatility of an investment, the wider the gap between the investment’s published return and the return that investors ultimately realize in that same investment.

Although these topics are almost always framed as “active vs passive” and “ETFs vs mutual funds,” advi-sors should consider marrying the best of both worlds. This will allow the portfolio to benefit from some cost savings without totally giving up the potential for raw or risk-adjusted outperformance. IE

Dan Hallett, CFA, CFP, is director, asset management, for Oakville-based HighView Financial Group., which designs portfolio solutions for advisors, affluent families and institutions.