Ignoring Sub-$100M ETFs: A Costly Idea

Published October 15, 2012

| Benzinga

Perhaps the worst number to come along in the history of exchange-traded products is $100 million. As in $100 million in assets under management means the fund is "good," it will survive and it is now profitable for the issuer.

The addiction to the $100 million in AUM equals a good ETF theory perhaps stems from a flawed report from McKinsey that used the number. That report takes a one-size-fits-all approach with the $100 million theory, but the reality is a fund's expense ratio plays a large part in the profitability of an ETF. Multiply an ETF's AUM by its expense ratio and there is an indication of the fund's revenue.

The $100 million in AUM number also does not take into account an ETF manager's ability to make money through securities lending, licensing fees or other external costs related to ETF management. Nor does it consider partnerships such as the one between Invesco's (IVZ) PowerShares and Deutsche Bank (DB) on ETFs such as the PowerShares DB Dollar Bullish (UUP).

In other words, the $100 million in AUM theory when it comes to ETFs is a lot of malarkey and that much has been proven. Still, some are attached to the number like they are attached to an old college fraternity sweatshirt wives beg husbands to get rid of.

Fatal Attachment References to 1980s movies aside, a fatal attachment might be different than a fatal attraction, but both are fatal. In this case, it is investors' portfolios that suffer on the advice that sub-$100 million ETFs should be shunned like Hester Prynne.

There are 14 equity-based ETFs with less than $100 million in AUM that have gained at least 20 percent year-to-date. Some are actually well known given their diminutive status. Others are not as risky as investors might have been lead to believe.

Even by treating the Market Vectors Egypt ETF (EGPT) and its almost 61 percent year-to-date pop as an outlier, there are still plenty of noteworthy performances among sub-$100 million AUM funds. Actually, EGPT should not be treated as an outlier because the ETFs has Apple (NASDAQ: AAPL), Amazon (AMZN) and Google (GOOG) this year. Apple is the closest and it still lags EGPT by more than 500 basis points.

Speaking of Egypt, a case can be made that the country's 19.1 percent weight in the Market Vectors Africa ETF (AFK) gain almost 22 percent this year. Naysayers would assert neither AFK nor EGPT are cheap. That would be correct as the funds charge 0.78 percent and 0.94 percent per year, respectively. So the average expense ratio between the two is 0.86 percent, but that comes nowhere close to putting a dent into an average gain north of 40 percent.

The List Goes On Investing in Africa is an acquired taste. Given elevated political volatility and opaque legal systems, among other concerns, it is understandable that some investors would want to pass on the continent. Still, are plenty of ETFs with less than $100 million in assets that have been on fire this year.

There is the case of the PowerShares Dynamic Building & Construction Portfolio (PKB). Under normal circumstances, PKB's 31 percent year-to-date gain would be impressive, but its larger rivals, the iShares Dow Jones US Home Construction Index Fund (ITB) and the SPDR S&P Homebuilders ETF (XHB) are up 63.2 percent and 44.2 percent, respectively.

While it is understandable that PKB has been overshadowed by its larger rivals, it is odd that with all the praise being heaped on shares of home builders this year, that this $41.5 million ETF does not get much press.

Staying at the sector level, investors that have opted for the giant Consumer Discretionary Select Sector SPDR (XLY) have been rewarded with a gain of 18.5 percent this year. They could have done better with the PowerShares Dynamic Leisure and Entertainment Portfolio (PEJ), which is up almost 21 percent.

PEJ, which has $53.1 million in AUM, is another example of some experts creating too much drama around low asset ETFs. The ETF is not home to obscure stocks as Yum! Brands (YUM) and Walt Disney (DIS), among other recognizable names, are found in PEJ's lineup. PEJ's average daily volume of just over 32,000 shares may not sound like much, but most of its underlying components are heavily traded, ensuring sufficient liquidity for the fund.

On a related note, the PowerShares S&P SmallCap Consumer Discretionary Portfolio (PSCD), which was designed to be the small-cap rival to XLY, has outperformed its large-cap cousin this year as well. PSCD is up almost 20 percent and has just $61.7 million in AUM.

Heading back overseas, investors need not have taken on excessive risk with sub-$100 million ETFs this year. Indeed, the aforementioned AFK and EGPT do qualify as "risky." There is also a fair number of other emerging markets funds that have surged more than 20 percent this year despite having less than $100 million in assets.

Investors could have skirted the emerging markets risk by heading to developed Europe. For example, the iShares MSCI Belgium Investable Market Index Fund (EWK) has gained almost 20 percent this year. That move is due in large part to bullishness in Anheuser-Busch InBev (BUD), which accounts for 23.5 percent of EWK's weight. That ETF has less than $29 million in AUM.

Critics would likely assert that risk is elevated with EWK because Belgium is a Eurozone member. Fair enough, but there is an answer. Investors could have avoided that risk and gained better returns by turning to Nordic ETFs. The Global X FTSE Nordic Region ETF (GXF) and the Global X Norway ETF (NORW) are up 20.1 percent and 22.3 percent, respectively, year-to-date.

Given Norway's solid GDP growth, a massive sovereign wealth fund and pristine balance sheet, assuming that the biggest risk to NORW is that is has less than $100 million in assets borders on the absurd.

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