ETFs with More Assets May Be Best

It may be in investors' best interest to favor ETFs that are at the high end of that genre's market capitalization array.

Advantages of ETFs vis-à-vis other modes of fund investments include a tendency of share prices to closely adhere to net asset values throughout the trading day. Besides revealing their portfolio holdings daily and transmitting their NAVs throughout the trading sessions, a mechanism unique to ETFs allows "qualified participants" to reduce or even eliminate the gaps between prices and NAVs using arbitrage.

But the "creation" and "redemption" units used to arbitrage differences between prices and NAVs are typically blocks of 50,000 to 200,000 shares. Small ETFs with trading volumes too thin to accommodate blocks of that size are likely to be more susceptible to chronic disparities between their respective market prices and NAVs.

In addition to premiums and discounts of price vs. NAVs, quotes of thinly traded ETFs are likely to involve relative hefty bid/asked spreads, which raise costs to investors on both sides of trades.

Despite the proliferation of new ETFs in recent years, on balance the segment remains relatively concentrated. An accompanying table compares concentrations of ETFs by size with similar data on open-end mutual funds and with traditional closed-end funds.

The biggest 1% of ETFs accounts for more than one-third of all ETF net assets. That's nearly double the percentage accounted for by the biggest 1% of open-end funds and it's more than four times the concentration of closed-end funds. The biggest 5% of ETFs accounts for nearly two-thirds of aggregate ETF net assets, with the biggest 10% making up just shy of 80% of the group's cumulative net assets.

These are all significantly greater concentrations of assets in the biggest players among ETFs than is the case with open-end funds or closed-end funds.

The same is largely true of trading volume. In the first two months of this year, dollar volume of ETF trading averaged $90.9 billion per day.

The concentration of dollar volume of ETF turnover, based on daily average volume, was as follows:

The largest 1% of ETFs, as ranked by average dollar volume of trading, accounted for 68.5% of the group's aggregate dollar turnover.

The biggest 2%, as ranked by average dollar volume of trading, accounted for 77.9% of cumulative ETF dollar turnover.

The biggest 5% accounted for 89.2% of total ETF dollar volume.

The biggest 10% (only 67 ETFs) totaled 95.1% of aggregate ETF dollar volume.

At the opposite end of the turnover spectrum, 18 ETFs averaged less than 500 shares per day during the first two months of 2008. Twenty-nine of the funds averaged less than 1,000 shares per day for the period -- a small fraction of the turnover required for effective arbitrage operations needed to keep prices and NAVs in close alignment.

This suggests that a sensible ETF strategy is to stick with the big, heavily traded funds. An investor wishing exposure to arcana such as metabolic endocrine disorder plays, Wal-Mart(WMT) suppliers or autoimmune-inflammation disorder investments (all of which are available in ETFs, by the way), would probably be wiser to invest directly in stocks rather than buying ETFs.

The adjoining table listing the 25 largest ETFs, besides containing the funds with the greatest liquidity, also provides ample diversity of investment possibilities.

The list is well represented in large-cap funds with two S&P 500 ETFs, the SPDR S&P 500(SPY) ETF and the iShares S&P 500 Index Fund(IVV).