Investors Cheating Themselves by Focusing on Largest ETFs

In the ETF game, size matters. As the exchange-traded products industry has evolved, professional and retail investors alike have become more obsessed with numbers. Underscoring the notion that a herd mentality still permeates financial markets, investors tend to find comfort in the largest, most heavily traded ETFs because those ETFs are big and heavily traded.

That is the case despite the fact that compelling evidence exists to suggest that bigger is rarely better when it comes to ETFs.

Perhaps what is most vexing is that this scenario is not confined to just one area of the ETF world. The conversation is not limited to a couple of China ETFs outperforming the iShares FTSE China 25 Index Fund (NYSE:FXI) or a fund or two being better alternatives than one of the sector SPDRs. The examples of small ETFs turning in stellar performances are too numerous to completely detail here.

There are some standouts worth examining, though. For example, the iShares Nasdaq Biotechnology Index Fund (NASDAQ:IBB) is, by most metrics, a fine ETF. Home to $2.5 billion in assets under management, the iShares Nasdaq Biotechnology Index Fund is the largest biotech ETF on the market. It has also performed quite well this year with a gain of 39.7 percent.

Chances are, few investors professional or retail would complain about making 40 percent in less than 10 months. On the other hand, those investors, particularly the retail crowd paying fees to advisors, probably would not be pleased to know that of the four major biotech ETFs, IBB is the worst performer on a year-to-date basis.

The fund IBB is closest to in terms of performance, the SPDR S&P Biotech ETF (NYSE:XBI), has outpaced IBB by over 300 basis points. The First Trust NYSE Arca Biotech Index Fund (NYSE:FBT) has topped IBB by 660 basis points. A biotech ETF that rarely gets the credit it deserves, the Market Vectors Biotech ETF (NYSE:BBH), has jumped almost 58 percent this year in near stealth fashion.

Proving that the bigger is not always better argument lingers across multiple sectors, there is the example of the First Trust Materials AlphaDEX Fund (NYSE:FXZ). At least this ETF has drawn some praise for trumping its rivals.

That is exactly what FXZ has done this year. In 2012, FXZ has topped the Vanguard Materials ETF (NYSE:VAW) by 150 basis points and the Select Sector Materials SPDR (NYSE:XLB) by almost 480 basis points.

Moving on from sector funds, broad market ETFs focused on a particular cap spectrum also give investors bigger is not always better examples. Take the case of the Guggenheim Wilshire Micro-Cap ETF (NYSE:WMCR). That ETF has just $13.4 million in assets under management compared to $478.6 million for the iShares Russell Microcap Index Fund (NYSE:IWC).

Chances are if Joe Six Pack asked his financial advisor to put him into a micro-cap ETF, the advisor would choose IWC because its large by assets and has decent volume for these type of ETFs at almost 80,000 shares per day. Joe would have every right to be mad at his advisor because the choice means being cheated out of almost 700 basis points of alpha this year.

Arguably, three examples is enough to make investors wonder if all they are getting with large ETFs is a security blanket by way of size. In the process, their returns may be suffering.

For more on smaller ETFs that are outperforming, click here.