Surprise, Surprise: Does Size Matter With ETF Returns?

There are plenty of instances in life when bigger is better. When it comes to exchange-traded products, bigger isn't always associated with better. At least when it comes to what should be investors' primary consideration: Returns. It has been documented that ETFs and ETNs with low average daily volume and an assets under management number that may not be viewed as impressive by the so-called experts can outperform. In fact, all investing in an ETF with a bigger AUM total does is lead investors to a bigger fund, not larger returns. Fortunately, a move away AUM and average daily volume as the primary determinants of an ETF's worth is already under way. "Some of the traders we talk to are using AUM and ADV a lot less now," said Chris Hempstead, head of institutional sales and trading at WallachBeth Capital. "Some hedge funds using ETFs to hedge might use the larger ETFs because they just need short-term exposure, but buy-side traders are using AUM and ADV less and less." The statistics back up the assertion that bigger isn't always better with ETFs. In an interview with Benzinga, Hempstead noted that in the case of the nine Select Sector SPDRs, all have been outperformed by a comparable fund of smaller stature on a year-to-date basis. Here are just a few examples. The $5.2 billion Consumer Staples Select Sector SPDR XLP trailed the iShares Dow Jones US Consumer Goods Index Fund IYK by more than 200 basis points as of the close of markets on April 20. The Energy Select Sector SPDR XLE, home to almost $7.5 billion in AUM, is negative on the year while the PowerShares Dynamic Energy Sector Portfolio PXI and its $143.1 million in AUM have generated positive returns. No one would deny the Health Care Select Sector SPDR (XLV), which is home to over $4 billion in AUM, is having a nice year, but the First Trust Health Care AlphaDEX FXH with "just" $597 million in AUM has offered better than double the returns of XLV. "I would argue that the excess return achieved in using the ‘less liquid' names far outweighs the often times falsely reported ‘excess cost' to trade these names. If a name is thinly traded, it is important to remember that the ADV is the least important number if total return is what you are looking to maximize," Hempstead said. The problem with money managers overlooking smaller, less liquid ETFs is the result is a viscous circle. According to WallachBeth data, there's $1.19 trillion in AUM at U.S. ETFs and ETNs, but the 75 largest funds hold $883.5 billion, or 74% of the overall total. When looking at average daily volume, the top 75 funds by that metric make 53% of total ETF/ETN assets. The top-10 most heavily traded ETFs alone account for 25% of total exchange-traded products AUM, according to WallachBeth. The vicious circle comes about by managers continuing to trade and pour money only into the biggest, most liquid names simply because those are the biggest, most liquid funds. That may give those managers some level of false comfort, but their clients would undoubtedly feel quite uncomfortable knowing their returns are being compromised. In the case of XLP, there are six other staples funds, including IYK, that have delivered better returns this year. Including PXI, four other equity-based energy ETFs have done better than XLE. Six health care funds have outpaced XLV while five other industrials ETFs have delivered better year-to-date returns than the Industrial Select Sector SPDR XLI, according to WallachBeth data. "Look, we expect that fund managers looking for quick (possibly even short term) and general exposure to a sector are going to first go to the most liquid product," Hempstead said. "That's okay. What we are encouraging is that if you have some time to do some research, ask some questions, look under the hood and consider all of your options and the costs therein you may find yourself with a smug grin of satisfaction knowing your money is exactly where you want it, all because you did a little bit of digging." For more on the bigger isn't always better debate, please click HERE.