Not many bank advisors use exchange-traded funds (ETFs). When they do, it's usually just to complement mutual funds and annuities. But Scott Frush, an independent-advisor-turned-bank-rep plans to establish his book using only ETFs to build diversified portfolios at bargain-rate costs for high-net-worth clients.

Many would argue that ETFs are an evolutionary improvement over mutual funds. They are similar to index mutual funds in that they are a passive basket of individual securities selected to replicate an equity or bond index, such as the S&P 500. But ETFs trade throughout the day like stocks, whereas mutual funds only tally their net asset value at the end of each day.

While it's true that index funds are cheaper than actively managed mutual funds, ETFs are cheaper still. Investing website, SeekingAlpha.com, compared ETFs with Vanguard's famously inexpensive index funds, and found that the management fee for a diversified portfolio of ETFs costs 18% less than a comparable portfolio of Vanguard index funds. Barclays iShares S&P 500 ETF, for example, charges nine basis points a year in fees, compared with 15 basis points for the Vanguard 500 Index Fund. And unlike mutual funds, ETFs allow investors to hedge a holding, by betting against the rise or fall of a certain sector.

ETFs are more tax-efficient too. While there's less turnover in passive funds than there is in active funds, and so less capital gains exposure, passive funds still expose investors to some capital gains from annual redemptions. Citing a Lipper study, SeekingAlpha.com reports that S&P 500 index mutual funds distributed 2.03% of their net asset value as capital gains each year, on average, between 1993 and 2001. By contrast, the iShares SPDR S&P 500 index ETF made only one capital gain distribution during that period, of 0.12% in 1996, and most S&P 500 ETFs are expected to make no capital gains distributions in the future.

Passive Impressive

Frush hits on all these advantages of ETFs, and clients have so far been receptive. Most of his high-net-worth investors already understand the advantages of passive investing: Eighty percent of active managers can't beat the index, and those who do have a much lower probability of doing the same the following year. "When you add in additional costs and capital gains liabilities from active management, a passive portfolio looks a lot more attractive," Frush says. "I ask clients, 'If you can't walk away with the gains you made in an active fund, did you really earn them?'"

Frush charges clients a recurring fee of 1% of assets under management and an average of 22 basis points in fees for the ETFs. For that, he designs a diversified portfolio of different ETFs and actively manages it for significantly less than his clients would pay for an active mutual fund. "Mutual funds can't touch this expense ratio," he says.

Frush wants to get the word out to other advisors about his strategy. "I think more advisors will adopt this strategy over time," he says. "My approach helps you brand your business, so you're not like everyone else selling mutual funds and annuities."

Perhaps the real benefit for advisors is the fee-based income. "If you sell a mutual fund, you might get 5% up front plus a 25-basis-point load," Frush says. "But with this program you get four times that load [1% a year] and over time you earn more than the initial 5%," which is only a onetime payment. The annual fee lasts as long as the client does. Plus, Frush gets to be the expert in his clients' eyes, not the middleman who helps them farm out their assets to a third-party manager they never get to meet. "That's very powerful," he says.

Still, some clients aren't interested in ETFs because they're a new and unfamiliar product, Frush says. "So really, it's an education hurdle." Luckily, Frush excels in client education as well. He won CFA Magazine's 2007 Most Investor Oriented award for excellence in client education, and he's written several consumer books on investing, including Commodities Demystified and Understanding Asset Allocation. "I use simple language" he says. "Most clients have heard of index funds, but not necessarily ETFs. When I describe ETFs in relation to index funds and stocks, it opens their eyes."

One client, a dentist with a $600,000 portfolio, was unhappy with his portfolio because it crashed with the market in October. The client didn't understand what was amiss. When Frush reviewed his portfolio, he saw that the client was holding almost all domestic equity mutual funds. "He was well diversified but not well allocated because he lacked exposure to different asset classes," says Frush. Frush was the first advisor to explain to the client the he could hedge equity risk with commodities and fixed-income ETFs to complement an S&P 500 core. The dentist signed on.