Hardly a week goes by without the launch of yet another exchange-traded fund (“ETF”). In fact, according to the Investment Company Institute, the number of ETFs increased from 724 to 832 during the year ended February 2010; a 15% increase. In contrast, the number of mutual funds declined from 8,020 to 7,677 over the same period. Further, the number of ETFs has grown at a whopping 26% annualized rate from only 80 a decade ago!

The proliferation of ETFs seems to be in response to product demand, be it real, imagined or contrived demand (remember the old adage “investments are sold, not bought”). What began as a reasonable endeavor to create low cost, relatively tax efficient, liquid vehicles, has turned into a race to build products that take increasingly targeted bets on investment opportunities in niche areas, not dissimilar to what has occurred in the mutual fund space. We believe that financial advisors who have latched onto this trend may be getting caught up in vehicle type rather than focusing on investment quality, and could be losing sight of the big picture.

Prima Capital has been serving wealth management organizations for over a decade, and many of our principals have been in this business for considerably longer periods of time. Over that time, we’ve observed that certain financial advisors tend to pigeonhole themselves into operating as “separate account” advisors, or “mutual fund” advisors, or increasingly, “ETF” advisors. In these cases, the focus is on the product type or vehicle rather than the underlying merits of the investment itself. As due diligence specialists, Prima Capital approaches manager evaluation, due diligence and selection from a vehicle agnostic perspective. Our first goal is to identify the highest quality asset managers and strategies available in order to meet the needs of our clients in the bank, brokerage, independent RIA and family office channels, who in turn advise affluent investors.

The vehicle in which a manager’s strategy is offered is certainly important at the implementation level, as cost, tax implications, transparency, liquidity, and other operational considerations require attention. But we see the vehicle type as distinctly ancillary to investment quality. This begs the question, how do we define “investment quality?” First and foremost, it’s about having a clear understanding about what financial advisors are trying to accomplish for their clients. We’ll refrain from a full blown financial planning discussion, but we would suggest that at the core is the determination of a required real, after-tax rate of return goal for each and every client portfolio. Everything else follows from that goal, and risk in all its forms should be mitigated to the greatest extent possible in the pursuit of that goal. To continue, investment quality is about a thoughtful, holistic approach to asset allocation, manager selection and risk management, with each of these “tools” utilized to solve different problems.

For financial advisors who have gone the ETF route, they’ve knowingly or unknowingly made a bet on passive versus active management, and have decided to differentiate themselves through strategic and/or tactical asset allocation, the importance of which becomes magnified with every step toward more granular sub-classifications (Taiwanese small cap stocks anyone?). We’ve concluded that many advisors have migrated toward ETFs out of frustration with manager selection, episodes of relative underperformance, and the expense of active management, all valid concerns, but at what cost to the client?

For example, should the investor forego the benefits that could be derived from a comparative analysis of the structural tax advantage of ETFs versus the ability of a separate account manager to actively harvest losses, or the opportunity to buy into embedded capital losses in a mutual fund? Or, should the investor forego the very real liquidity premiums that can only be mined properly in illiquid investment vehicles? Would you want your client to miss the opportunity to allocate capital to a manager with genuine insight and a true investment edge simply because that manager doesn’t happen to manage a mutual fund? Or a separate account? Or an ETF?

As the financial advisor, do you acknowledge that with the ability to access a specialty ETF, say a water resources focused ETF, that doing so requires a well-thought-out viewpoint on the expected return, risk and correlation characteristics of such a portfolio bet? Or do you simply distill down what should rightly be a complex decision into a simple one: water is scarce, demand is real, and so the stock prices of companies involved in water processing and distribution will “go up.” We think adherence to this practice abrogates professional responsibility.

If this article is interpreted as being anti-ETF, we would respectfully observe that the point has been missed. The theme is not about investment product type or vehicle, which is a portfolio implementation issue; rather, it’s about investment quality. As long-time readers of this column may know, Prima Capital serves as Portfolio Strategist to series of multi-manager portfolios. Within these portfolios, we work from a strategic perspective to build broadly diversified portfolios to take advantage of the true global investment opportunity set; we utilize both active and passive managers to balance costs with alpha generation; and we embrace true open architecture to harness the skill sets and experience of a diverse set of high-quality asset management teams that we believe have unique market insights.

However, we are relatively indifferent as to the vehicles through which we access those managers. Each vehicle type has advantages and disadvantages, and the selection of each investment must be done with a clear eye on investment quality and the impact that each manager or vehicle will have on a client’s total portfolio…and the real after-tax rate of return generated by that portfolio.

We offer these methodologies as best practice guidelines for financial advisors who may be questioning the way they work in order to not only survive but thrive in these uncertain times, and challenging economic and market conditions.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital (www.primacapital.com), which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.