Why Small-Cap ETF Liquidity Concerns Aren't A Big Deal

by: Tom Lydon

Small-cap exchange traded funds have quietly returned robust gains this year, but some investors pass over the ETFs due to lower asset levels or thinner trading volume. Yet potential investors shouldn't write off small-cap ETFs solely on liquidity concerns.

The Guggenheim China Real Estate ETF (NYSE:TAO) is this year's best performing China-themed ETF, gaining 40% so far this year, but many overlooked the fund based on the fact that it has $46 million in assets under management, writes Brendan Conway for Barron's.

The story is similar with other below-$50 million small-cap ETFs, like the $8.8 million RevenueShares Financials Sector Fund (NYSEARCA:RWW), which is up 23% year-to-date; the $25 million PowerShares KBW Premium Yield Equity REIT Portfolio (NASDAQ:KBWY), which is up nearly 18%; the $4 million SPDR S&P Mortgage Finance ETF (NYSEARCA:KME), which is up 24%; and the $16 million IQ U.S. Real Estate Small Cap ETF (NYSEARCA:ROOF), which is up nearly 21%.

Many financial advisors have steered clients away from funds with less than $100 or $50 million.

"You don't want to go into a dark theater that doesn't have any exits," Dryden Pence of Pence Wealth Management said in an ETF Roundtable, arguing that investors should avoid funds that could shut down or pose problems if one needs to sell off a large position quickly.

However, the common notions of liquidity can not be associated with ETFs, since the funds are only as liquid as their underlying securities.

"I wouldn't shy away from ETFs that have low volume or low assets. You just have to be smart about how you trade it," Eric Lichtenstein, managing director of Knight's ETF trading desk, said in the Barron's article.

ETF investors should always use limit orders to better control trade executions at certain prices. Vanguard ETF strategist Joel Dickson advises "pegging" an ETF order at a certain point away from the bid/ask price.

"It protects you from the 'flash-crash' scenario," Dickson said in the Barron's article.

Max Chen contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.

Additional disclosure: Mr. Lydon serves as an independent trustee of certain mutual funds and ETFs that are managed by Guggenheim Investments; however, any opinions or forecasts expressed herein are solely those of Mr. Lydon and not those of Guggenheim Funds; Guggenheim Investments; Guggenheim Specialized Products, LLC or any of their affiliates.