Investors have gravitated toward the largest exchange traded funds for any given market segment, largely overlooking smaller funds in the process.
While investors should look at all the options before committing to an investment, it is important to consider the potential implications of trading smaller ETFs. Specifically, investors have to look at the overall costs, both explicit and implicit.
"Despite the growth in ETF assets in recent years, some ETFs are traded infrequently and cost more than alternatives," writes Todd Rosenbluth, S&P Capital IQ Director of ETF Research, in a research note.
Rosenbluth highlights the fact that "ETFs with limited asset bases tend to have higher expense ratios, less liquidity due to limited trading activity, and trade above or below their net asset value, thus costing more."
All of these factors could lead to wider bid/ask spreads and higher premiums or discounts to the net asset value. Consequently, the market inefficiencies would lead to lower potential returns. These two cost factors are considered when S&P Capital IQ provides its rankings.
For instance, the analysts hold an "underweight" ranking for the PowerShares Fundamental Pure Small Cap Core Portfolio (NYSEARCA:PXSC), which has $15 million in assets and trades just over 800 shares daily. According to Morningstar, PXSC has a 0.45% bid/ask spread and currently sits at a 1.09% discount to its NAV.
On the other hand, the S&P analysts have an "overweight" ranking for the iShares Russell 2000 Index (NYSEARCA:IWM), which has $19 billion in assets and trades over 30 million shares per day. According to Morningstar, IWM has a 0.01% bid/ask spared and trades at a 0.06% premium to its NAV.
Max Chen contributed to this article.