To most investors, bigger is better when it comes to exchange-traded funds. The 20 largest ETFs account for nearly half of the $1.2 trillion in total industry assets. Of the remaining 1,400-plus U.S. listed exchange-traded products, the majority house less than $100 million in assets and have average daily trading volumes of less than 100,000 shares.
Despite a rash of ETF closings in recent months, advisors are not throwing smaller ETFs out of client portfolios indiscriminately. Many of these smaller ETFs have a unique investment methodology that offers an alternative to traditional, passive market-cap-weighted indexes. Some of these funds are rules-based. Others target a specific investment area that would be difficult or expensive to access through a mutual fund or stock.
Such features have attracted financial advisor Gregory Skidmore, the president of Belpointe Asset Management in Greenwich, Conn. He began using the IQ Global Resources ETF (GRES) three years ago as a proxy for the commodities market. Instead of using futures contracts, as most natural resource funds do, this fund follows a basket of natural resource-related stocks such as Exxon Mobil and Goldcorp. It also hedges exposure to global equities through short selling.
Skidmore says using natural resource stocks instead of futures eliminates contango, a problem that arises when maturing futures contracts must sell and roll into more expensive ones, losing the investor money. At the same time, the short exposure helps filter out the stock market noise. "It's closer to a pure commodity play than you're going to get with most commodity ETFs," he concludes. At one point, Skidmore considered a larger ETF that invests in the stocks of commodity-related companies, but he eventually stuck with the IQ offering because of its equity market hedging strategies.
He also uses the WisdomTree Total Dividend fund (DTD), which follows U.S. companies, and the WisdomTree DEFA fund (DWM), which zeros in on dividend payers in Europe, the Far East, Asia and Australasia. He believes the company's proprietary indexing methodology, which ranks companies according to dividends and earnings, makes more sense than traditional indexes governed by stock market capitalization.
Paul Frank, manager of the ETF Market Opportunity Fund, invests in a number of lower volume ETFs to corner specific parts of the market, including the iShares Dow Jones U.S. Aerospace & Defense Index Fund (ITA). He also owns the First Trust NYSE Arca Biotechnology Index Fund (FBT), which has been around since 2006. The index gives equal weighting to each of its components, which he prefers over market-cap-weighted indexes.
But not all smaller ETFs strike his fancy. "I won't invest in inverse and leveraged ETFs because they are too risky and don't own the underlying shares," he says. "I also stay away from very specialized ETFs that have illiquid holdings. There's just too much that can go wrong from a trading standpoint."
Todd Rosenbluth, an ETF analyst at S&P Capital IQ, cites the Market Vectors Bank & Brokerage fund (RKH) as a less actively traded ETF worth considering. Launched in 2011, the fund owns some of the same banks and financial services companies that its larger competitors do, names such as JP Morgan Chase and Citigroup. But because of its global focus, the fund also has foreign holdings such as Toronto Dominion. "The index it uses is also rules-based, so there is more of an active slant here," Rosenbluth says.
Another smaller ETF, the SPDR MSCI ACWI IMI fund (ACIM), follows a broad-based global index of developed and emerging market securities that's similar in composition to the much larger Vanguard Total World Stock fund (VT). Rosenbluth favors the SPDR product because its portfolio skews toward what he considers higher-quality companies.
There is some evidence to suggest that smaller ETFs perform at least as well, and sometimes better, than larger ones. In July, a study by TrimTabs compared the performance of high-volume and low-volume ETFs over a nine-month period ended June 30 and found that the latter group did slightly better. Of the 20 top-performing ETFs so far this year, 10 of them trade less than 50,000 shares a day, according to Morningstar's ETF database.