Exchange-traded funds. Mention these words to a group of Canadian investors and advisors, and you will more than likely get many different definitions and suggested investment applications. There is enormous confusion over the features and benefits of ETFs, and which types of investor profiles best suit this investment vehicle.

One of the most common beliefs in the traditional investment community is that ETFs are designed explicitly for the do-it-yourself investor. There is no doubt that ETFs are a fantastic investment vehicle for the pure DIY market. What is not yet as well known is that ETFs are also perhaps one of the most powerful, solution-oriented investment tools to hit the Canadian wealth-management advisory business in the past decade.

I recently attended the second annual Exchange-Traded Fund conference in New York City on Sept. 26. Standing room only. All the ETF players were there. ETF manufacturers such as State Street Global Advisors and Barclays Global Investors, index providers such as Standard & Poor's and Dow Jones, and large U.S. brokerage firms such as Merrill Lynch and Solomon Smith Barney all attended. The conference clearly focused on users being institutional managers, investment managers and asset managers.

ETFs are investments that contain a pool of securities representing a specific index such as the Dow Jones industrial average or the S&P 500. There are now close to 100 ETFs that can be purchased on the Toronto Stock Exchange or on the American Stock Exchange in the United States. They represent different geographic areas, industrial sectors, style quadrants and capitalization levels.

ETFs are built like mutual funds but trade like stocks. They are attractive to individuals, institutional investors and investment advisors alike because they provide liquid, cost-efficient exposure to a broad range of asset classes. Unlike regular open-end mutual funds, which are valued based on closing prices, ETFs can be bought and sold throughout the trading day. They can also be sold short and bought on margin. In brief, anything you might do with a stock, you can do with an ETF.

Herein lies some of the confusion. Exchange-traded funds are one of the most flexible, multi-purpose investment vehicles available in the marketplace. Institutional managers such as pension funds, mutual fund managers and hedge fund managers may all use ETFs for issues such as cash equitization, risk management or transition management. These institutions are inclined to use these instruments as short-term trading vehicles.

Investment advisors, wealth managers and individual investors, however, can use ETFs as an excellent asset-allocation tool. These types of investors are inclined to use ETFs as long-term buy-and-hold vehicles.

The reality is that both groups are exceptionally well served by exchange-traded funds. According to Gus Fleites, director of Exchange-Traded Funds for State Street Global Advisors, "ETFs are really the first investment vehicle that in essence can satisfy both groups of investors, the traders as well as long-term buy-and-hold investors."

Canadian investment advisors should explore the possibility of building private client diversified investment portfolios or core equity components using exchange-traded funds.

Gone are the days when ETF investing was limited to the Toronto 35 index participation units (TIPs) or the S&P depositary receipts (SPDRs.) Although these indexes have done exceptionally well over the past decade, the traditional investment community always pointed to the over-weighting in Nortel Networks Corp. and in the large-cap growth companies in each of these respective indexes as the reasons for their great long-term performance.

Times have changed. Today, investment advisors and counsellors can create global investment portfolios tailored to their clients' risk tolerance and then monitor, rebalance and maintain long-term portfolio focus on behalf of their clients by using ETFs.

These globally diversified portfoli advice formula may not appeal to the kind of investor who is constantly looking for the next "home run." It will, however, appeal to the Canadian investor who has already created his or her wealth. These kinds of investors tend to be a little older, a little wiser, a little bit more experienced -- and they tend to have the real wealth.

An annual management fee of 0.75% to 1.5% depending on assets under administration should be charged. Say what! An annual management fee to manage a group of index-based exchange-traded funds? This seems counter-intuitive. Or is it?

Many studies have shown that only a small portion of individual investors can, in fact, maintain the investment discipline required for obtaining good long-term portfolio management results. There is a tendency for individual investors to over-trade their long-term strategic asset allocation, chase performance, lose patience with stalling asset classes and fail to monitor diversification and risk in their portfolios. Good advisory programs mitigate all of these issues.

Even Canada's DIY independent investor Bylo Selhi (whose comments on ETFs are frequently quoted in Canadian newspapers) sees a place for ETFs in a comprehensive advisor service proposition. "Financial planning entails much more than portfolio management, including income, taxation, estate, insurance, etc. planning. Few do-it-yourself investors have either the knowledge or inclination to do all of that by themselves."

U.S private client advisory firms have been using passive asset class investment vehicles for years. Dimensional Fund Advisors Inc., based in Santa Monica, Calif., with US$35-billion under administration, has been creating its own special passive asset classes for both institutions and independent private client advisory firms since 1981. It trains advisors to focus on long-term discipline coupled with well-diversified portfolios across multiple asset classes. These are DFA's keys to long-term investment success.

"We are partly in the business of redefining the traditional advice giving model. The traditional definition of advice from an investor's point of view was finding an advisor who could determine in advance when certain stocks would go up or down or could determine when to get in or out of the market," says Weston Wellington, DFA's vice-president.

"The bad news is that DFA advisors cannot tell in advance what's the next hot stock, or when to time the market," Mr. Wellington says. "The good news is that you do not have to, and that they have created the techniques and the strategies for advisors and their clients to have very successful investment plans."

There are many other well-known U.S.-based advisory firms that are essentially managing private client portfolios using low-cost well-diversified index-type asset classes under an annual management fee approach.

Most of the programs do, however, tend to focus on a more affluent client base. Evensky, Brown & Katz, one of the best-known and most-quoted wealth-management firms in the United States, currently uses a type of "core and explore" approach. Peter Brown, president of the group, states that most of its "clients' exposure to large-cap growth and large-cap value are achieved through index- based portfolio management."

Even firms like The Vanguard Group, considered by many the king of retail index funds, sees a market for clients who are seeking continual portfolio assistance under a management fee environment. Jack Bogle, chairman and founder of Vanguard, believes there are investors who need advice and those who do not. For those investors who need advice, he states, "the best advisors can help you develop a long-term investment strategy and an intelligent plan for its implementation. In all, paying a reasonable price for guidance -- especially when the advisor helps minimize your all-in cost [his or her cost, plus the costs of the funds] by focusing on low-cost funds -- may well be acceptable in light of the services

Keith Matthews is an investment advisor and partner at PWL Capital Inc., which is licensed to conduct business in Ontario and Quebec.