An important change is taking place in the world of wealth management. In the past, investors looking to outperform the market would turn to actively managed mutual funds or even hedge fund managers looking for that performance.

But with the advent of exchange-traded funds, a new cadre of sophisticated financial advisers have emerged that are using passive instruments like ETFs to implement active portfolio management strategies that search out strong returns while managing risk.

Kim Arthur is part of this new group of advisers. As the founder and CEO of Main Management LLC in San Francisco, Arthur manages more than $325 million in sophisticated ETF-only strategies. He spoke recently with IndexUniverse.com to explain how he does it, and what areas of the market are attractive right now.

IndexUniverse.com (IU.com): Tell me a bit about your firm.

Kim Arthur, CEO, Main Management LLC (Arthur): The firm was founded seven years ago, with the prevailing philosophy that we wanted to be a fiduciary for our clients and provide them with a liquid, transparent, diversified wealth management solution.

When we looked around to see what products were available to help us achieve that end goal, we found ETFs [exchange-traded funds]. There were about 100 ETFs available at that time, and now there are about 900, and more are being added all the time.

We started out in 2002 with $25 million in assets, and we’re now at $325 million. Along the way, the embedded fees in the ETFs have come down, and the liquidity has increased dramatically. We have been able to pass those savings on to our clients.

IU.com: What attracted you to ETFs?

They were liquid, transparent and diversified, and they had the additional benefits of being low cost and tax aware.

IU.com: What strategies do you offer?

Arthur: We started with a single strategy focused on sector rotation domestically. But today, we have six strategies, including a global portfolio allocation strategy, which we see as a one-stop solution for wealth management. [The other strategies include] international, buy-write and more. We can also put options overlays on our portfolios to manage risk and create cash flow streams.

IU.com: How do you approach building an ETF portfolio? How do you decide how much to allocate to what and where to place your bets?

Arthur: We have an institutional-grade advisory board, half of whom are former Wall Street strategists or economists, and we work with them to look at the markets from 30,000 feet. We dig into interest rate forecasts, spreads, currency movements and a great deal more.

Based on the input from our advisory board and from trusted sources we’ve built up over the years on Wall Street, we decide where we are in the economic cycle and where we are going, and we use that to put a strategic allocation in place.

We then switch to a bottoms-up approach, testing various hypotheses and looking back to see how different asset classes have responded to various market conditions in the past.

We also believe in reversion to the mean in sector valuations, so we’ll look at the 10 sectors and compare their valuation today vs. historical valuations at different points in the business cycle. If a sector is attractive on both valuation and timing, we will make an allocation.

The final check we do is from the bottom up. Everyone in the company comes from a single-stock background, so we will talk to C-level people at businesses to find out how things are looking for them: Are they seeing lean inventories, where are things in the product cycle, etc. We realize that sectors and markets can stay cheap a lot longer than you expect, unless you have a catalyst that will drive investors back to a theme. We look for that catalyst, and we also make intra-year changes as market conditions evolve.

The last piece we do is an options overlay. We sell covered calls against a portion of the equity allocation, giving some downside protection while forfeiting some of the upside exposure. We use options overlays as a volatility damper and a way to manage risk in the portfolio.

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