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For years, do-it-yourself investors have been flocking to exchange-traded funds for their low cost, diversification and trading flexibility.

Now, ETFs are also growing in popularity with financial advisers, a trend that is helping to change the way they charge clients for their services.

Traditionally, many advisers used a transaction-based compensation system in which they earn commissions for executing trades or selling mutual funds. But the move to low-cost ETFs is going hand-in-hand with a shift to fee-based compensation, in which the adviser charges a percentage of the client's assets instead.

Advisers say it's a win-win for them and their clients, because costs are usually lower and fees are more transparent than under the traditional system.

"The trend is toward fee-based advice and, in particular, toward fee-based advice with ETFs," said John DeGoey, associate portfolio manager and certified financial planner with Burgeonvest Bick Securities in Toronto.

"People like to be able to know what they are paying. The industry trend is toward transparency, and this does that in a way commissions wouldn't," Mr. DeGoey said.

According to Mr. DeGoey, 10 years ago fewer than 5 per cent of advisers were using a fee-based ETF model. Now, he estimates that one-third of advisers have moved to fee-based compensation, and of those most are using ETFs in some capacity.

In addition to keeping costs down, it creates a more predictable earnings stream for the adviser and his or her firm, he said. In many cases, the fees may also be tax deductible.

Usually, clients need a fairly significant amount of assets to qualify for a fee-based account. Mr. DeGoey, for example, generally has a minimum account size of $250,000. He charges 1.4 per cent on the first $250,000, and 0.6 per cent on any amounts over that. So a client with $500,000 would pay a blended fee of 1 per cent.

Even as more advisers and portfolio managers gravitate to ETFs, there are differences in the ways they use the products, which are similar to mutual funds but which can be traded on an exchange throughout the day.

Mr. DeGoey uses ETFs as part of a passive strategy, which involves choosing an appropriate asset allocation of equities and fixed-income securities based on the client's age, goals and risk tolerance, and then tweaking the portfolio only when the weightings stray outside predetermined guidelines.

While the diversification of ETFs makes them ideal for such a passive approach, some portfolio managers use ETFs as part of a more active trading strategy in an attempt to beat the market.

Keith Richards, portfolio manager and owner of ValueTrend Wealth Management in Barrie, Ont., prefers ETFs because he can easily trade in and out of sectors, based on whether he thinks they are undervalued or overvalued.

Mr. Richards charges a flat fee of 1 per cent and prefers clients to have a minimum of $1-million, although he sometimes goes as low as $500,000 if he sees potential for growth. He says using a fee-based model with ETFs reduces potential conflicts of interest.

"You're not being paid by a mutual fund company to buy their funds, and it eliminates churning [excessive trading]for commissions," he said. "The only way I can get a raise is to make your portfolio grow. If I can turn your $1-million portfolio into $1.1-million, we both win."

Another reason he likes ETFs is that he doesn't become attached to his holdings, whereas with individual stocks there's a risk that emotions might get in the way. He also likes the fact that ETFs are liquid, making it easy to trade in and out at a fair price.

The use of ETFs by advisers "is growing like crazy," said Mr. Richards, who uses products from iShares, Claymore, Horizons and Bank of Montreal in client accounts.

Others caution, however, that using ETFs in a fee-based account isn't necessarily the best approach for everyone. For instance, a buy-and-hold client who seldom trades might end up paying more under a fee-based system than with a commission-based account, said Garth Rustand, executive director of the Vancouver-based Investors-Aid Co-operative of Canada.

Investors also need to realize that, in an asset-based compensation system, the adviser's annual fee isn't the only expense they'll be paying. The client also pays the ETF's management expense ratio (MER), which is deducted from the assets of the fund.

That's fine if the MER is low, but many ETFs have expense ratios of between 0.5 per cent and 1 per cent. Combine that with the asset-based fee of 1 per cent to 2 per cent, and the cost advantage of using ETFs can quickly vanish.

"The fees can add up," Mr. Rustand said. That's why it's important to negotiate with your adviser to get the lowest fee possible.

Some investors may be better off setting up a simple do-it-yourself index portfolio using TD e-series mutual funds, or buying actively managed mutual funds from a low-cost provider such as Phillips, Hager & North, he said.

Even with a passive portfolio of ETFs, however, some investors want the comfort of having an adviser to manage their account, provide financial planning advice and – perhaps most important – hold their hand through periods of market turbulence. That's one reason that ETFs and fee-based accounts are growing in popularity.

"There's clearly an appetite for it," Mr. DeGoey said. "And it is, in my opinion, mutually beneficial for both the adviser and the client."

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