This Small ETF Dispels False Liquidity Views

Exchange traded funds have been around in the U.S. for over two decades. One would think that would be enough time for professional investors to figure out two important facts regarding equity-based ETFs.

First, no empirical evidence exists to suggest that small ETFs, often deemed that way for having less than $100 million in assets under management are "bad." In fact, ample evidence exists to the contrary.

Second, if it is the ETF's underlying holdings that drive the fund's performance, and it undoubtedly it is, then it is also those holdings that help determine an ETF's liquidity. A recent article on sector ETFs that was found on at least on reputable financial outlet indicates some investors still do not get those two basic principles.

The writer of the piece claims the PowerShares KBW Property & Casualty Insurance Portfolio KBWP is not sufficiently liquid because it has less than $100 million in AUM. He goes on to say "I recommend investors only buy ETFs with more than $100 million in assets. The fact that 9 out of the 10 best sector ETFs have over $100 million in assets, and 8 out of 10 have more than $1 billion, suggests that investors are getting better at identifying the best sector ETFs."

As it pertains to KBWP, the advice is dubious at best because ETFs with heavy exposure to insurance providers have been stellar performers this year. Not to be trite, but the fact that eight of the writer's top-10 sector ETFs have over $1 billion in AUM means no more than that investors are proficient at pouring money into already large ETFs, i.e. following the herd.

Yes, KBWP is small. It has just $33.3 million in assets, but the ETF has provided big returns this year with a gain of almost 17 percent. In the past 12 months, KBWP is up 27.7 percent. Over the past two years, the ETF has surged 36.5 percent. That is a lot of alpha to sacrifice just because an ETF is not the most popular kid at the party.

As for liquidity, the least heavily traded of KBWP's top-10 holdings, a group that accounts for about 57 percent of the fund's weight, is ProAssurance PRA. That stock has average daily of about 228,500 shares over the past three months. Three of KBWP's top-four holdings have average turnover north of 1 million shares and Chubb CB barely misses that mark at 993,000 shares per day.

Two of the ETF's top three-holdings, Allstate ALL and Progressive PGR have volume over 3 million shares per day. KBWP's top-three holdings, which represent 23.6 percent of the ETF's weight, are up an average of 15.1 percent year-to-date, something to consider when evaluating the fund's components.

In further proof KBWP is sufficiently liquid, the mid-point of its bid/ask spread rarely exceeds its net asset value. Rarely as in almost never. Almost never as in during 2012's 250 trading days and the 60 trading days in the first quarter of this year, KBWP's bid/ask mid-point never reached even a 50 basis point premium or discount, according to PowerShares data.

The reality is the worst thing anyone can say about KBWP is that it is a small ETF. To each their own, but ignoring all small ETFs is no guarantee of large returns. KBWP proves as much.

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