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,
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
SPDR S&P 500
ETF and the
iShares S&P 500 Index Fund
For large-cap growth, there is the
iShares 1000 Growth Index Fund
iShares S&P 500 Growth Index Fund
. On the value side of large cap, there is the
iShares 1000 Value Index Fund
iShares S&P 500 Value Index Fund
Similarly broad representation is available in the table for small cap and mid cap investments.
International representation varies from the broad geographic coverage of the
iShares MSCI EAFE Index Fund
to the subcategory of emerging markets -- the
iShares MSCI Emerging Markets Index Funds
Vanguard Emerging Markets ETF
-- to other ETFs specializing in Japan, Brazil and China.
For fixed-income needs, the list contains a short-term Treasury fund, an inflation-protected Treasury fund and an investment grade general bond fund.
Sector funds in the table include gold and energy.
The large ETFs in the table have generally served their holders well by returning, on average, 8.88% over the 12 months ended Feb. 29. That compares with a negative total return of 3.60% for the S&P 500 total-return index, and an average of minus 1.44% for the ETFs that didn't make the biggest-25 list. Helping the largest of the breed was an average expense ratio of only 0.28%, which amounts to half the average levy extracted by the remaining ETFs.
The largest 25 ETFs also held closer in market prices to their respective NAVs, on average, than the remaining funds.
The ETFs in the table represent 59.9% of the total net assets of all ETFs.
Richard Widows is a senior financial analyst for TheStreet.com Ratings. Prior to joining TheStreet.com, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.