[LightDestory]

First just to reply to @ikk157 there is a easier way to do that: it is called persistent installation and software like Rufus can make it with a ISO and a USB drive without emulating an installation.
I have to say that this particular installation is possible thanks to a recently fix provided by Rufus' developer to the Linux community and it works on distributions that merged this patch: Debian, Ubuntu, ect...

I don't know if the mentioned small linux distros are well updated as normal distros. If your target distro is not compatible with Rufus, well you have already describe the only way to get a persistent installation of Linux on a USB drive.

To @xdude and @"Hidden Refuge" Don't you know that we can actually run Linux from RAM? It is faster then running a OS from a USB 3.0 (that on older machine will be downgraded to 2.0).

There are a few distros that runs directly from ram and the requirement of ram is a mind-blowing range!
You start froma distros called SliTaz that works 64MB of RAM!
SliTaz is an extreme and really bare-bone Linux distro, if you get more RAM you can choose between more distros that are more likely "daily usage".
IF you get 2GB+ of RAM I suggest:

• Tin Hat Linux, the last release is 4 year ago but it is the so far stable and rich distros of this type.
  
• Slax, a good distro capable of running on RAM and stays persistent if good conditions meet.
  
• Puppy Linux, the most famous lightweight distro that can ALSO run from ram.
  

I will not list every Distros capable of running from RAM, you can find a useful list on Wikipedia from this link

Regards,

LightDestory.