Picking from the multitude of sector ETFs is a daunting task. In any given sector there may be as many as 45 different ETFs, and there are at least 181 ETFs across all sectors.

Why are there so many ETFs? The answer is: because ETF providers are making lots of money selling them. The number of ETFs has little to do with serving investors’ best interests. Below are three red flags investors can use to avoid the worst ETFs:

  1. Inadequate liquidity
  2. High fees
  3. Poor quality holdings

I address these red flags in order of difficulty. Advice on How to Find the Best Sector ETFs is here. Details on the Best & Worst ETFs in each sector are here.

How To Avoid ETFs with Inadequate Liquidity

This is the easiest issue to avoid, and my advice is simple. Avoid all ETFs with less than $100 million in assets. Low asset levels tend to mean lower volume in the ETF and large bid-ask spreads.

How To Avoid 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 an expense ratio below 0.52%, which is the average expense ratio of the 181 US equity ETFs I cover. Weighting the expense ratios by assets under management, the average expense ratio is lower at 0.32%. A lower weighted average is a good sign that investors are putting money in the cheaper ETFs.

Figure 1 shows the most and least expensive sector ETFs in the US equity universe based on total annual costs. ProShares provides 4 of the most expensive ETFs while Fidelity ETFs are among the cheapest.

Figure 1: 5 Least and Most-Expensive Sector ETFs

Screen shot 2014-05-02 at 3.14.13 PMSources: New Constructs, LLC and company filings

ProShares Ultra Consumer Goods (UGE) and Direxion Daily Financial Bull 3X Shares (FAS) are two of the most expensive U.S. equity ETFs I cover, while Fidelity MSCI HealthCare Index ETF (FHLC) and Schwab U.S. REIT ETF (SCHH) are the least expensive. The more expensive UGE and FAS receive my 3-star or Neutral rating, while the cheapest ETFs, SCHH and FHLC, receive my 2-Star rating and 3-Star rating respectively. One of the most expensive ETFs, UGE earns a better rating than three of the cheapest ETFs. Quality holdings can make up for high costs.

However, investors need not pay high fees for good holdings. Fidelity MSCI Consumer Staples Index (FSTA) is my highest rated sector ETF and earns my 4-Star or Attractive rating. It also has low total annual costs at only 0.13%.

On the other hand, Fidelity MSCI Energy Index ETF (FENY) and Fidelity MSCI Consumer Discretionary Index ETF (FDIS) hold poor stocks. And no matter how cheap an ETF, if it holds bad stocks, its performance will be bad.

This result highlights why investors should not choose ETFs based only on price. The quality of holdings matters more than price.

How To Avoid ETFs with the Worst Holdings

This step is by far the hardest, 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. The sectors are listed in descending order by overall rating as detailed in my 2Q Sector Rankings report.

Figure 2: Sector ETFs with the Worst Holdings

Screen shot 2014-05-02 at 3.13.35 PMSources: New Constructs, LLC and company filings

My overall ratings on ETFs are based primarily on my stock ratings of their holdings. My firm covers over 3000 stocks and is known for the due diligence done on each stock we cover.

iShares appears more often than any other provider in Figure 2, which means that they offer the most ETFs with the worst holdings. iShares Industrial/Office Real Estate Capped ETF (FNIO) has the worst holdings of all Utilities ETFs. IEO, IYZ, and ITB all have the worst holdings in their respective sectors.

Note that no ETFs with a Dangerous portfolio management rating earn an overall rating better than two stars. These scores are consistent with my belief that the quality of an ETF is more about its holdings than its costs. If the ETF’s holdings are dangerous, then the overall rating cannot be better than dangerous because one cannot expect the performance of the ETF to be any better than the performance of its holdings.

One of the cheapest ETFs, FDIS, gets my Dangerous rating because its holdings get my Dangerous rating. Similarly, SCHH, also one of the cheapest ETFs, gets a Dangerous portfolio management rating and, therefore, cannot earn anything better than a 2-star or Dangerous overall rating. Again, the ETF’s overall rating cannot be any better than the rating of its holdings.

Find the ETFs with the worst overall ratings on my ETF screener. More analysis of the Best Sector ETFs is here.

The Danger Within

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. As Barron’s says, investors should know the Danger Within. Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance.


Best & Worst Stocks In these ETFs

Bank of America Corp (BAC) is one of my least favorite stocks held by FAS and earns my Dangerous rating. With the news of BAC suspending their share buyback and dividend increase, investors must take a closer look into the fundamentals of BAC. BAC’s after-tax profit (NOPAT) has declined by 1% compounded annually over the last decade while their return on invested capital (ROIC) now stands at a bottom quintile 3%. In addition, BAC has generated negative economic earnings in 15 of the last 16 years. These fundamentals do not support the valuation of BAC. To justify the current price of ~$16/share, BAC would need to grow NOPAT by 9% compounded annually for the next 40 years. These expectations seem overly optimistic given the long-term track record of BAC and the current regulatory environment.

Equity Residential (EQR) is one of my favorite stocks held by SCHH and receives my Attractive rating. Over the past ten years, EQR has grown NOPAT by 11% compounded annually. The company currently earns a ROIC of 11% as well. Despite strong profit growth, EQR remains undervalued. At its current price of ~$59/share, EQR has a price to economic book value (PEBV) ratio of 0.9. This ratio implies that the market expects EQR’s NOPAT to permanently decline by 10%. Given the strong track record of growth by EQR, this expectation seems very pessimistic. Low expectations and strong fundamentals make EQR an attractive investment.

Kyle Guske II contributed to this article

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

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