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.