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Small ETFs That Deserve More Assets

Active or passive, an ETF investor can reap rewards by venturing off the beaten path.

Samuel Lee, ETF Analyst, 04/19/2011

The Case for Unpopular Indexes
Investors rightly associate size with stability and low costs, but rigidly sticking to giant ETFs can lead investors astray. Flawed index construction can overwhelm the expense ratio and liquidity advantage big ETFs enjoy. Some of the biggest funds, such as those following the S&P 500 and Russell 2000, lose a lot of money to front-running arbitrageurs.

Active ETF investors should be wary of so-called enhanced ETFs that attempt to beat the market, especially when they get bloated with assets. Like active managers, even the best active indexes have limited space to execute their strategies. It's hard enough as it is to earn alpha--saddling a previously outperforming index-based strategy with too many assets can wipe out the mispricing it exploits. Almost by definition, the best-returning strategies will usually be ones that had limited capital dedicated them.

Active or passive, ETF investors can reap rewards by venturing off the beaten path and either avoiding unnecessary but hidden costs, or improving their chances of finding unexploited opportunities.

With over 1,200 exchange-traded funds, we figured a few good ideas were bound to slip through the cracks. So, we dug for treasure among the 1,000 ETFs that haven't passed $1 billion in assets and found a few gems that could supplement your portfolio.

United States Commodity Index USCI
$453.7 million

Futures-based commodity index investors have been hurt by a one-two punch of contango and price impact. Contango dragged some long-futures-based funds down by 10 percentage points or more. To add insult to injury, they've lost about 3% annualized over the past decade to price impact, according to a recent paper by Columbia University professor Yiqun Mou.

USCI cleverly sidesteps much of these issues by exploiting backwardation (the opposite of contango) and momentum. Yale professor K. Geert Rouwenhorst and his partners at SummerHaven designed the index based on their academic research. It's rare for an active-strategy ETF to have such intellectual firepower behind it.

In a dramatic vindication of Rouwenhorst's research, the fund has outpaced every broad commodity ETF by an average of 8% since its launch last August, and its outperformance came from consistent monthly gains rather than a few anomalous periods. If you must have long futures-based commodity exposure, get this fund.

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