Why bigger ETFs are usually better

ETFs with larger market capitalizations are cheaper to buy and maintain

Published: March 05, 2015 07:15 PM

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Although there were already more than 1,600 exchange-traded funds available to U.S. investors, almost 200 new ETFs were rolled out in 2014. However, 88 of them also closed last year, according to ETF.com. Among the casualties: four PIMCO ETFs focused on foreign bond funds and 17 leveraged funds from ProShares. Being an industry leader doesn’t make an ETF invulnerable: Even ETF giant BlackRock closed more than a dozen of its iShares ETFs in 2014.

The official reasons given are usually put in polite, corporate terms, but the real reason ETFs close is because traders and investors decide they don’t want to invest in them. That could be due to either a too-crowded market­place for a particular product (there are already plenty of leveraged ETFs for institutional traders, for instance) or because there’s little appetite for the latest ETF flavor that a firm has concocted (as was the case for the target-date ETFs that iShares issued). Consider that on an aver­age trading day, more than 130 million shares of the most active ETF, the SPDR S&P 500 ETF (ticker: SPY), change hands. By contrast, for most of the shuttered funds, fewer than 1,000 shares traded daily.

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There are other reasons that lightly traded ETFs do investors few favors and that investors may want to avoid them altogether. First, they tend to be smaller than actively traded ETFs in terms of market capitalization, and there’s an inverse relationship between market capitalization size and the expense ratio. Larger ETFs typcially have an annual expense ratio of just 0.20 percent, and sometimes even less than that. By contrast, the shuttered, low-asset ETFs would have cost investors more—an average of 0.70 percent.

Second, lightly traded ETFs, like lightly traded stocks, tend to have higher bid-ask spreads than more liquid investments. In other words, you’ll need to pay more to buy those ETFs, and you’ll probably have to accept less when it comes to selling a thinly traded ETF than you would if you were selling a more liquid ETF.

When shopping for an ETF to add to your portfolio, look for the largest ones, with market capitalizations in the tens of billions of dollars. The economies of scale allow them to keep their expenses low, and the high volume over the major stock exchanges keeps the bid-ask spreads to a minimum.

 —Chris Horymski

Editor's Note:

This article also appeared in the March 2015 issue of Consumer Reports Money Adviser

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