How To Avoid the Worst Style ETFs 2Q16

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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 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 average or below average fees, invest only in ETFs with total annual costs below 0.48%, which is the average total annual cost of the 294 U.S. equity Style ETFs we cover. The weighted average is lower at 0.17%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows that Madrona Domestic ETF (FWDD) is the most expensive style ETF and Schwab U.S. Large-Cap ETF (SCHX) is the least expensive. WBI Tactical (WBID, WBIB, and WBIF) provides three of the most expensive ETFs while Schwab (SCHX and SCHB) and Vanguard (VOO and VTI) ETFs are among the cheapest.

Figure 1: 5 Least and Most Expensive Style ETFs

NewConstructs_LeastMostExpensive_StyleMFs_2Q16

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings. Schwab U.S. Large Cap Value (SCHV) earns our Very Attractive rating and has low total annual costs of only 0.07%.

On the other hand, Vanguard Small-Cap Growth Index (VBK) holds poor stocks yet charges total annual costs of only 0.09%. 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 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

NewConstructs_AvoidWorstStyleETFs_2Q16

Sources: New Constructs, LLC and company filings

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

ProShares Ultra Oil & Gas (DIG) is the worst rated ETF in Figure 2. PowerShares Russell 2000 Equal Weight (EQWS), PowerShares Russell MidCap Pure Value (PXMV), Vanguard Small-Cap Growth Index (VBK), Oppenheimer Ultra Dividend Revenue (RDIV), and Guggenheim S&P SmallCap 600 Pure Value (RZV) earn a Dangerous predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs too.

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.

PERFORMANCE OF ETFs HOLDINGs = PERFORMANCE OF ETF

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

Click here to download a PDF of this report.

Photo Credit: Christopher Cotrell (Flickr)

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