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 issue 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 cost of the 293 U.S. equity Style ETFs we cover. The weighted average is lower at 0.16%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows ETF Series Solutions AlphaClone ETF (ALFA) is the most expensive style ETF and Schwab US Large-Cap ETF (SCHX) is the least expensive. ETFS Trust (ZSML, ZLRG) provides two of the most expensive ETFs while Schwab (SCHX, SCHB, SCHG) ETFs are among the cheapest.

Figure 1: 5 Least and Most Expensive Style ETFs


Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings. Schwab U.S. Large Cap ETF (SCHX) earns our Very Attractive rating and has low total annual costs of only 0.03%.

On the other hand, Vanguard Russell 2000 Value Index Fund (VTWV) holds poor stocks and earns our Dangerous rating, yet has low total annual costs of 0.22%. 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 avoid bad ETFs, but it is also the most important because an ETFs performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each style with the worst holdings or portfolio management ratings.

Figure 2: Style ETFs with the Worst Holdings


Sources: New Constructs, LLC and company filings

PowerShares (EQAL, DWAQ, PXMV, EQWS, PXSG) appears more often than any other provider in Figure 2, which means that they offer the most ETFs with the worst holdings.

ProShares Ultra Telecommunications (LTL) is the worst rated ETF in Figure 2. Guggenheim S&P Small Cap 600 Pure Value (RZV), PowerShares Russell 2000 Equal Weight (EQWS), PowerShares Russell 2000 Pure Growth (PXSG), and Guggenheim Raymond James SB-1 Equity (RYJ) earn a Dangerous predictive overall rating, which means not only do they hold poor stocks, they also 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. Don’t just take our word for it, see what Barron’s says on this matter.


This article originally published here on February 9, 2017.

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

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