If you're a scientist, you look back. If you're an artist, you look forward. Financial advisors often have to be a little bit of both.

For advisors with an artistic bent, exchange-traded funds have emerged as a welcome tool, putting another weapon in an investment arsenal that was starting to age.

These index funds, which trade throughout the day like stocks, have been around since 1993, when Standard & Poor's introduced S&P 500 Depository Receipts (known as "Spiders"). But last year saw an ETF renaissance.

The amount of assets invested in ETFs mushroomed to $77.5 billion by the end of April, according to the American Stock Exchange. That compares with $35.9 billion at the end of 1999.

Barclays Global Investors spurred a lot of the enthusiasm with its introduction of iShares last year. The firm's current 61 iShare products cover everything from growth and value sectors to large- and small-capitalization stocks to countries to sectors.

For advisors, these new vehicles have opened up unplowed territory, ripe for innovation in asset allocation, tax strategies and hedging. That's good news, even if ETFs currently are benefiting more from the market slump. Faced with declining portfolio values, advisors are using ETFs to take advantage of loopholes in the wash-sale rule to harvest tax losses-offering a tonic to investors who saw their assets decline.

It's tax efficiency more than anything else that has caused mutual fund investors to come peeking over the fence at ETFs. Many fund investors, though they suffered losses in portfolio values, still took a large tax bite in April because their funds had realized big capital gains. Exchange-traded funds, meanwhile, are much more efficient since, for one thing, changes to the underlying indexes are not considered taxable events.

They also are more transparent. Some advisors insist that with ETFs, they now can implement asset-allocation model strategies with real integrity because they no longer are dealing with the guesswork of mutual fund holdings.

ETFs "allow us to decompose expected returns in various components," says Al Coles of Financial Design Associates in Stinson Beach, Calif. "When you implement with a mutual fund, it dilutes the process. With index funds and iShares, you can generate rigorous expected returns and implement and adjust accordingly."

This implementation makes the advisor, rather than the fund manager, responsible for adding value, Coles says. Of course, naysayers abound, complaining mostly that exchange-traded funds, because they trade through brokers, are laden with commissions that can eat up returns. ETF fans call this an execution issue rather than a product problem.

"We've heard that discussion," says Thomas Mench, chairman of Mench Financial in Cincinnati, which executes its trades at 3 cents a share or less. "It's a problem if you use [ETFs] as a trading vehicle. But we use them as an asset-allocation tool. ... We've found that our transaction costs have been running less than one-eighth of 1% per year in terms of transaction costs to the client."

Asset Allocation

Gene Balliett of Balliett Financial Services and Trust Co. in Winter Park, Fla., uses two or three ETFs in his aggressive models and mixes these with traditional no-load funds.

He keeps 30% of his portfolio in about three mutual funds at all times. Then, depending on the strength of the market, he will invest the next 30% in three of four ETFs. The other 40% goes to individual stocks, a total of eight securities with about 5% each. If the stocks in his list show momentum, he supplants the exchange-traded funds with equities. The flexibility allows him to duck out of the market quickly.

"I could get into [ETFs] this morning and out again, in theory," Balliett says. "Suddenly, there might be something in midday that makes me realize I don't want to be invested today. If somebody bombs the White House, for instance."

Balliett only uses those ETFs with the highest trading volume. These include the Diamonds Trust Series (DIA, based on the Dow Jones Index), Spiders, the S&P 400 Mid-Cap Depository Receipt (MDY) and Nasdaq 100 Shares (QQQs, also known as "cubes"). Because he typically buys shares in $10 million to $20 million blocks, he doesn't feel comfortable owning the vast majority of ETFs because most are thinly traded. He figures the volume will improve, however, when the stock market bounces back.

Mench's firm has been building complete portfolios of nothing but ETFs for high-net-worth individuals and institutions. The firm utilizes five specific styles.

According to Mench, ETFs allow advisors to do several things to optimize asset-allocation models. Advisors can build portfolio strategies specific to risk tolerance. They can allow tactical adjustments to asset allocation on a monthly basis. They can create broad diversification with just a few securities. And they also can allow their clients to tilt portfolios to sector and size specifications.

Its core growth portfolio, for example, uses a core S&P 500 index. The firm then can choose from 11 S&P sector funds, tilting for growth or value.

Managing Taxes

Another approach that is gaining popularity among advisors is that used by Jay Shein, a CFP licensee with Compass Financial Group in Lighthouse Point, Fla. It focuses on harvesting tax losses.

"Say I have a large growth index," Shein says. "I sell it and expose it to tax losses. Within a minute, I can buy another index and keep my exposure. Another way is selling out of a money manager or a regular mutual fund. One client had a separate account with a money manager. We sold out and bought the index that was the actual benchmark. After 30 days, we sold it and went back to the money manager and got a tax loss a second time."

The proliferation of iShares has allowed advisors to deploy this strategy in a number of different ways. It's especially effective if an investor has heavily concentrated stock positions.

"Say there's a portfolio with a low basis of stocks that you're selling out over time," Shein says. "You want to redesign the portfolio and sell the [highly appreciated] stocks over a three-year period. You could buy a lot of little pieces of the market-buy technology, buy financial services and cyclicals. Some will go up, and some will go down. And you'll create losses."

For instance, he says, if a client owns $1 million in IBM, he or she can sell out of a third of that and invest in sector Spiders. Naturally, some of those sectors will go down before the end of the year, helping pay for the realized gains on the IBM stock sold in the first place. At the same time, the portfolio is gradually becoming more diversified.

Hedging And Sector Rotation

The huge boom in ETF product also has allowed investors to come up with inventive uses for market correlation and hedging strategies.

Often, advisors will take on a new client with a basket of undesirable stock positions that can't be sold, says Bernard Kiely of Kiely Capital Management in Morristown, N.J. Frequently, he doesn't want to assume the exposure of selling out of a big position or sector. Or perhaps it's the client's company stock. ETFs, then, allow the advisor to keep the security, but short the index.

"If my client is transferring a basket of technology stocks, I have no control over them until they arrive," says Robert Levitt of Levitt Capital in Boca Raton, Fla. "I might short the QQQ to reduce the exposure to technology."

"Before, [investors] didn't really have access to these outperformance strategies," says Jon McConaughy, head of ETFs at Credit Suisse First Boston. "So they can now buy stocks they think are going to outperform their industry and then sell a sector against it."

Investors also can short-sell ETFs on a downtick. That "gives people short exposure to industry groups they didn't have before," McConaughy says. "The fact that you don't need an uptick allows people to short industry groups, regardless of whether or not they are long or short on the stocks."

Mutual funds, by contrast, can't be sold short. And even if they could be, it's difficult to tell how to measure them, since there's no telling what's really in them or whether you are shorting a pure style.

ETFs also offer possibilities for market-correlation strategies. Advisors who bet that the Spiders shares won't go too far afield of Diamonds can predict how one fund will go up shortly after the other, says Kevin Ireland, a marketer for the American Stock Exchange.

Clients' Feelings

"Eighty percent of the people who walk into my office, if I asked them what ETFs are, they don't know," Shein says.

Mench, however, disagrees, arguing that retail investors largely have been receptive to ETF products. It's commission-based advisors with the bias against the product, he says.

"I've spoken at major conferences," Mench says, "and one of the things I've found quite interesting is that clients have a better grasp of these things than some broker-dealers or institutional marketers. Clearly, the retail market has been looking for something to fill their immediate need. But there hasn't been an incentive for commission-based brokers or advisors to use these."

However, don't be surprised if some ETFs with loads for commission-based brokers start surfacing soon.