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.

Out Of The Spotlight
Despite some of their appealing qualities, less actively traded ETFs are for various reasons often shunned by advisors, says Rosenbluth. "Many are brought to market by smaller firms with limited marketing budgets, so there is often a lack of brand-name recognition," he says. "People are more comfortable going with what they know, and a lot of the firms offering smaller ETFs aren't well known to them."

Investors in thinly traded ETFs have see many of these funds close. In 2010 and 2011, providers turned off the lights on 87 such ETFs. (Among those companies shutting down portfolios were FaithShares, WisdomTree, Direxion, PowerShares and Rydex.) In August of this year, FocusShares announced plans to close all of its 15 funds, while Direxion shuttered nine ETF offerings and Russell confirmed it will close all but one ETF.

Illiquidity is another concern. Because the price of an individual company's shares can be moved by large orders when trading volume is low, investors also assume that ETF prices could be vulnerable in those cases where there are a limited number of shares on the market.

But ETFs work differently. When a large order comes in for an ETF, the authorized participant can expand supply fairly quickly by creating new shares. ETF promoters say this unique elasticity helps keep supply in line with demand and minimizes differences between the price being offered for a stock (the "bid") and the price at which another party is willing to sell (the "ask.")

Still, there is some debate about how effective the creation and redemption process is in narrowing bid/ask spreads for smaller, thinly traded issues. Some financial advisors say smaller ETFs just aren't geared to accommodate larger transactions.

"Most of our trades move across client accounts, so it isn't unusual for us to buy or sell $1 million worth of securities or more at a time," says Diane Pearson of Legend Financial Advisors in Pittsburgh. "Our concern with smaller ETFs is that our activity could have an impact on prices."

The underlying basket of securities could also pose a problem. If these funds or underlying stocks or bonds trade infrequently, the authorized participant could have trouble getting the securities needed to generate new ETF shares. That problem hits large and small ETFs alike.

To Frank, the liquidity of underlying holdings is a greater concern than ETF trading volume. "People get caught up in how many shares an ETF trades during the day, but the biggest determinant of liquidity is how frequently the underlying stocks trade," he observes.

Tips For Trading
While it's more challenging to buy and sell smaller, thinly traded ETFs than it is larger ones, financial advisors who use small funds say there are steps you can take to make transactions go more smoothly.

1. Always use limit orders. Because the shares of many smaller ETFs may not trade hands for a day or more, bid-ask spreads can be wider than they would be if the security had a higher trading volume. So advisors who use smaller ETFs recommend avoiding market orders, which authorize a broker to place an order immediately at the best available price. Instead, these advisors use limit orders, which specify a price at which they are willing to buy or sell.

Frank usually ignores the market price. Instead, he sets prices for buy and sell orders at no more than "a penny or two" from an ETF's intraday intrinsic value, which reflects the per share net asset value of its holdings. To find a stock's intraday intrinsic value, type in its normal ticker followed by ".IV."

2. Get help. Throwing a large order into the market, even if you use a limit order, may not get you the best possible price on a thinly traded ETF. Instead, advisors should contact a broker who will work with them to fill the order at the best possible price.

It's especially important to get help if an order exceeds 10,000 shares, or more than 50% of an ETF's daily trading volume, Skidmore says. "You don't want to come in with a huge, unexpected order and have the price move on you because of it," he cautions. With very large orders, he will often contact the ETF provider for execution to make sure he gets the best possible price. While smaller providers have been responsive, Skidmore says one larger firm was less than helpful on the execution side with one of its lower-volume offerings.

3. Watch the clock. Some experts advise against placing orders at the beginning and end of the trading day, which are usually the most volatile times for the market. Trades involving international ETFs are also more likely to run more smoothly when those markets are open, especially for large orders.

4. Consider the risk of closure. Since smaller ETFs are usually unprofitable for the providers, the companies sometimes close them and leave shareholders with a tax bill and other headaches. It's hard to figure out which ETFs are likely to close, but if the past is any indication, it's less likely to happen at larger firms. Vanguard, State Street and iShares have the financial heft to support less-profitable, smaller ETFs, so product closures at those firms are extremely rare. Of the 87 exchange-traded products that shut down in 2010 and 2011, only two were housed at one of the big three ETF players.

According to Matt Hougan of IndexUniverse, ETFs with assets of more than $30 million are unlikely to shut down since they are profitable for providers. Nor do new funds normally bite the dust; even if trading is slow for the first six to nine months, the issuers will likely hang in and wait for things to improve. If an ETF has a unique niche, it is also less likely to close than a fund with 10 or 20 competitors offering similar exposure.