From the April 2013 issue of Investment Advisor • Subscribe!

April 1, 2013

Do Not Fear Small ETFs

When it comes to ETFs, assets under management aren’t everything

Conventional wisdom often provides obstacles to properly analyzing an ever-growing universe of exchange-traded funds. In previous columns, we’ve discussed how misunderstandings related to ETF liquidity can cause investment advisors to unnecessarily limit their universe of investable ETFs and potentially miss out on funds that best suit their objectives. A related mistake, which we will address in this column, is to overemphasize the importance of an ETF’s assets under management, especially when using this factor to eliminate funds from consideration if they fail to meet certain minimum AUM thresholds.

Not surprisingly, misunderstandings related to ETF liquidity are often at the heart of investment advisor concerns related to smaller funds. It’s feared that trades that are relatively large compared to a fund’s asset base may “move the market.” However, this misapprehension is often rectified when advisors come to understand how the ETF creation and redemption process adds a secondary level of liquidity to fund shares, thereby facilitating relatively large trades compared to the size of an ETF, with minimal impact on ETF share prices.

Another widespread concern about smaller ETFs has been the fear that fund sponsors may eventually decide to pull the plug on these funds. Considering the fact that 2012 was a record-breaking year for ETF closures, such concerns warrant further scrutiny.

On the surface, a relationship between the size of an ETF and its risk of closure seems intuitive. After all, ETFs with significant AUM do not usually close down. On the other hand, the assumption that all small ETFs face an equally high risk of closure is exceedingly flawed. Eight of the 11 largest ETF sponsors, each with at least $9 billion in total ETF AUM, have never closed down an ETF (excluding one bond ETF whose original objective was to close upon maturity), despite the fact that these firms manage a significant number of smaller ETFs. This, of course, does not mean that they will never choose to close down an ETF in the future, but it does shed light on the fact that decisions to do so are largely driven by the respective business models (and in some cases, financial condition) of fund sponsors. Therefore, when evaluating the probability that a small ETF may close, investment advisors should pay close attention to whether or not the fund’s sponsor has closed down any ETFs in the past, as this may reveal a firm’s disposition toward closing funds, rather than simply grouping all small ETFs together.

With regard to those ETF sponsors that have decided to close down ETFs in the past, the process has generally been much less painful for investors than one might suppose, especially considering the level of effort that some have undertaken to avoid these funds. Rather than suddenly delisting ETFs without warning, fund sponsors have generally announced their intentions several weeks in advance in order to provide investors ample opportunity to sell ETF shares. Those deciding not to sell in advance of an ETF closure have received cash for their shares when the fund is finally liquidated. While this process may trigger an unwanted tax event, along with the inconvenience and cost of reinvestment, there has generally been little else to worry about.

On the other hand, in the process of avoiding smaller ETFs in favor of their larger counterparts, many investment advisors have also eschewed some of the best performing funds in recent years. As an illustration, an investor in the largest ETF (by AUM) from each of Morningstar’s U.S. style-box categories five years ago underperformed the best performing fund from each respective category by an average of four percentage points per year (as of Dec. 31, 2012). The average size of the eventual best performers from each category was $61 million at the end of 2007 versus the average size of the largest ETF from each category at $17.3 billion.

Of course, it does not follow that smaller funds will always outperform larger funds or vice versa. In most cases, ETF size has little or nothing to do with future ETF performance. In our opinion, fund size should generally play a very small role (if any) in the analysis of ETFs from a given asset class. Instead, investment advisors should focus more attention on fund attributes that make larger contributions to relative levels of risk and return, emphasizing differences in the rules by which underlying indexes select, weight and rebalance holdings.

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