Talk about going all the way.

Exchange-traded funds, or ETFs, are no longer a secret among fund managers seeking an extra dose of diversification. ETFs, which are mutual funds that trade on exchanges like stocks, can be found in countless open- and closed-end mutual funds. But the folks at AdvisorOne funds believed so much in the potential of ETFs that a few years ago they switched their two hallmark funds to all-ETF formats.

So far the move has been a smashing success. ( CLSAX) AdvisorOne Amerigo, the more aggressive of the two funds, is benchmarked to the S&P 500 and is up 5.1% -- 2.7 percentage points better than the index. ( CLERX) AdvisorOne Clermont, the more conservative fund, uses a blended benchmark of 45% S&P 500 Index and 55% Lehman 1-5 Year Government Credit Index. Clermont is up 1.6% year to date. Since the conversion to ETFs, combined assets of the AdvisorOne funds have increased from $50 million to in excess of $800 million.

TheStreet.com chatted with Bob Jergovic, portfolio manager of the two funds, about the pros and cons of going all the way with ETFs.

When and why did you decide to start an all-ETF portfolio?

The AdvisorOne funds were started in 1997 as fund-of-funds, or mutual funds that invest in other mutual funds. The original intent of the funds was to provide individuals who may not meet our account minimums access to our investment process.

We started an ETF-only investment strategy in 2001. It got off to a rather modest start. For the most part, ETFs were still a relatively new investment vehicle to many investors and financial planners. In August of 2002, we took a hard look at our two mutual funds, which at the time had combined assets of approximately $50 million, and came to the conclusion rather quickly that the fund-of-funds structure was too cumbersome and too expensive to serve as an effective investment vehicle. Exchange-traded funds were the right tool at the right time for us.

Being an active asset allocation firm, the ETF solution was tailor-made for our investment process. So we began converting Amerigo and Clermont to ETFs from actively managed mutual funds to exchange-traded funds.

What are the advantages of using nothing but ETFs?

The widely touted advantages of ETFs to investors are their low cost, liquidity, transparency, intraday trading capabilities, can be shorted, tax efficiency. They provide instant diversification. Options are also available on ETFs.

While all these advantages are appealing, transparency was a big plus for us. With traditional mutual funds, it is very difficult to determine why the fund is performing as it is, since you do not know what securities the fund may be holding at any particular time. With ETFs, transparency enables the investor to "lift the hood" and see what is driving performance. For us, knowing what we are buying and why it is performing is important.

What are the disadvantages?

The biggest disadvantage of exchange-traded funds is that, like equities, there is a ticket charge for executing the purchase or sell order. For smaller investors, that could be cost-prohibitive, or at least offset some of the low-cost advantage to ETFs. Also, to the best of my knowledge, providers have not yet found an effective way to enable investors to dollar cost average ETFs. If there was, that would open up ETFs to the 401(k) universe.

Our way around dollar cost averaging in 401(k)s has been to use a "core and explore" strategy using our two mutual funds as well as other traditional funds. Also, given that exchange-traded funds track indexes, outperformance from superior stock selection is eliminated.

How do you decide on an asset allocation?

For an individual client, a risk profile is completed, identifying their objectives and tolerance for risk. Each client is then assigned a "risk budget." While many managers attempt to control risk by a rigid stock-to-bond ratio -- like 60% equity vs. 40% bond for a conservative client -- we focus on the volatility of the allocation.

Once the risk budget is determined, we evaluate the performance of the exchange-traded funds on a risk-adjusted basis over multiple time periods. At that point, we begin to make decisions as to which asset classes we want to overweight, underweight or eliminate from consideration. It is a process of quantitative inputs and qualitative output.

Right now you hold a high percentage of emerging-markets stocks in your portfolio. Is this a statement about the American market? Is this a high-risk strategy?

The allocations within the AdvisorOne funds does change over time. Focusing on Amerigo, the more aggressive equity fund, in early 2003, the fund had no exposure to emerging markets, and total developed international exposure was approximately 7%. Our developed and emerging-market exposure peaked in 2004 at just over 40% and currently resides in the low 30s with a higher exposure to emerging markets.

When investors think of emerging markets, they think of what emerging markets were 10 or 20 years ago. Most of the emerging markets now have investment-grade debt ratings, are experiencing rapid economic growth, yet they still carry a relatively low valuation because they are still classified by investors as "emerging." The potentially big win for investors would be the revaluation of many of the emerging markets to developed markets as their P/Es increase from, for example, 10 times earnings to the 17 times earnings that many developed markets are valued at.

How much do your funds cost?

The expense ratio of the funds is 1.15%. The approximate expense of the underlying ETFs in the portfolios is 0.35% for Amerigo and 0.25% for Clermont. Our trading costs for the ETFs are running approximately 1.5 cents per share. If we want to exit a position, it is less costly for us to exit an entire ETF position compared to what it would cost us to exit several different equity positions comprising a similar size position.

The emerging-market exposure in Amerigo raises the internal cost of the ETFs while the bond exposure in Clermont lowers the internal expense. Obviously, the internal expense will vary as the allocations change. At 1.4% to 1.5% total expense, that placed the funds in line with the average "A" share fund in Morningstar.

Is this type of ETF-only portfolio something investors can try at home without a professional helping them?

Exchange-traded funds are available to all investors, be they institutional investors or the retail investor who enjoys managing their own investments. If an individual investor has the time, desire and skill level to determine their investment objectives, know their tolerance for risk and how the different asset classes interact, they can indeed build their own portfolio allocation. The key point is that exchange-traded funds are a "tool"; they don't become a "solution" until they are put together into a portfolio directed toward a goal.

You mix and match ETFs from different fund families. Do you see a big difference between the different brands offered such as Vipers, iShares, SPDRs and streetTracks? How do you discriminate between them?

We evaluate ETFs of the different providers based on the index they track, liquidity and the expense ratio. For the most part, we have utilized iShares and SPDRs. More recently we have begun to utilize Vipers.

Lately there have been very specialized ETFs offered by companies like PowerShares. Does getting too specialized reduce the utility of an ETF?

We have tended to stay with the more traditional ETFs. Transparency is very important to us, and we are not inclined to purchase an ETF with a "black box" strategy attached to it. That is not to say that other investors may not find them attractive. If we were to find a particular subsector that was attractive, we would look into the individual equities that made up that subsector and purchase them rather than move to a highly specialized ETF.

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