How To Avoid the Worst Sector ETFs 1Q16

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Question: Why are there so many ETFs?

Answer: ETF providers tend to make lots of money on each ETF so they create more products to sell.

The large number of ETFs has little to do with serving your best interests. Below are three red flags you can use to avoid the worst ETFs:

  1. Inadequate Liquidity

This issue is the easiest to avoid, and our advice is simple. Avoid all ETFs with less than $100 million in assets. Low levels of liquidity can lead to a discrepancy between the price of the ETF and the underlying value of the securities it holds. Plus, low asset levels tend to mean lower volume in the ETF and larger bid-ask spreads.

  1. High Fees

ETFs should be cheap, but not all of them are. The first step here is to know what is cheap and expensive.

To ensure you are paying at or below average fees, invest only in ETFs with total annual costs below 0.49%, which is the average total annual costs of the 182 U.S. equity Sector ETFs we cover. The weighted average is slightly lower at 0.28%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows that PowerShares KBW High Dividend Yield (KBWD) is the most expensive sector ETF and Schwab U.S. REIT ETF (SCHH) is the least expensive. ARK ETF Trust (ARKQ and ARKW) provides two of the most expensive ETFs while Vanguard ETFs (VIS, VDC, VGT, and VHT) are among the cheapest.

Figure 1: 5 Least and Most Expensive Sector ETFs

NewConstructs_AvoidWorstSectorETFsTotalAnnualCosts_1Q16

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings. Market Vectors Semiconductor ETF (SMH) earns our Very Attractive rating and has low total annual costs of only 0.39%.

On the other hand, Schwab U.S. REIT ETF (SCHH) holds poor stocks. No matter how cheap an ETF, if it holds bad stocks, its performance will be bad. The quality of an ETFs holdings matters more than its price.

  1. Poor Holdings

Avoiding poor holdings is by far the hardest part of avoiding bad ETFs, but it is also the most important because an ETF’s performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each sector with the worst holdings or portfolio management ratings.

Figure 2: Sector ETFs with the Worst Holdings

NewConstructs_AvoidWorstSectorETFs_1Q16

Sources: New Constructs, LLC and company filings

PowerShares (PSCC, PTH, and PSCU) appear more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings.

U.S. Telecommunications ETF (IYZ) is the worst rated ETF in Figure 2. PowerShares DWA Healthcare Momentum Portfolio (PTH), PowerShares S&P Small Cap Consumer Staples (PSCC), ARK Innovation ETF (ARKK), and Fidelity MSCI Real Estate Index Fund (FREL) also earn a Very Dangerous predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs.

Our overall ratings on ETFs are based primarily on our stock ratings of their holdings.

The Danger Within

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance.

PERFORMANCE OF ETFs HOLDINGs = PERFORMANCE OF ETF

Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, or theme.

Click here to download a PDF of this report.

Photo Credit: Andrew Butitta (Flickr)

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