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 183 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 183 US equity ETFs I cover. Weighting the expense ratios by assets under management, the average expense ratio is lower at 0.33%. 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. Direxion provides three of the most expensive ETFs while Fidelity ETFs are among the cheapest.

Figure 1: 5 Least and Most-Expensive Sector ETFs 

Screen shot 2014-02-13 at 9.44.36 AMSources: New Constructs, LLC and company filings 

Direxion Daily Natural Gas Related Bull 3x Share (GASL) and ProShares Ultra Consumer Services (UCC) are two of the most expensive U.S. equity ETFs I cover, while Schwab U.S. REIT (SCHH) and Vanguard REIT (VNQ) are the least expensive. The more expensive RETL and UCC receive my 2-star or Dangerous rating, while the cheapest ETFs also receive my 2-Star rating. One of the most expensive ETFs, Direxion Daily Financial Bull 3x Shares (FAS), 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 ETF (FSTA) is my highest rated sector ETF and earns my Attractive rating. It also has low total annual costs of only 0.13%.

On the other hand, SCHH and VNQ 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 1Q Sector Rankings report.

Figure 2: Sector ETFs with the Worst Holdings 

Screen shot 2014-02-13 at 9.43.50 AMSources: 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, PowerShares and SPDR ETFs appear more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings. iShares FTSE NAREIT Industrial/Office Capped Index Fund (FNIO) has the worst holdings of all Financials ETFs. PowerShares Dynamic Food & Beverage, PowerShares Lux Nanotech Portfolio (PXN), iShares Dow Jones U.S. Home Construction Index Fund (ITB), State Street SPDR S&P Telecom ETF (XTL), and PowerShares S&P Small Cap Utilities Portfolio (PSCU) 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.

Figure 2 reveals that one of the cheapest ETFs, PSCU, gets my Dangerous rating because its holdings get my Dangerous rating. Similarly, SPDR S&P Biotech ETF (XBI), 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

Amazon.com Inc. (AMZN) is one of my least favorite stocks held by RETL and UCC and receives my Very Dangerous rating. Over the past five years, AMZN’s after-tax profits (NOPAT) have declined by 1% compounded annually. Over the same time frame AMZN’s return on invested capital (ROIC) has decreased from 27% to a bottom quintile 4%. As I wrote in May of 2013, and more recently, AMZN’s valuation implies an unrealistic level of profitability and growth. AMZN’s recent track record does not suggest it can achieve significant NOPAT growth. In 2013, AMZN’s NOPAT margin continued its decline to 0.7%, down from 1% the year before. At the current price of $361/share, the market expects AMZN to increase NOPAT by 26% compounded annually for 24 years. In the highly competitive arena of online retail this expectation seems highly unrealistic, especially when coupled with AMZN’s shrinking margins.

Chevron Corporation (CVX) is one of my favorite stocks held by FENY and receives my Attractive rating. Over the past decade, CVX has increased after-tax profits (NOPAT) by 20% compounded annually and currently earns a return on invested capital (ROIC) of 11%. Despite this consistent growth, CVX remains undervalued. At ~$112/share, CVX has a price to economic book value (PEBV) ratio of 0.75. This ratio implies that the market expects CVX’s NOPAT to permanently decline by 25%. With such pessimistic expectations and a strong history of growth, CVX presents a great opportunity for investors.

Kyle Guske II contributed to this article

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

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