Finding the best ETFs is an increasingly difficult task in a world with so many to choose from.

You Cannot Trust ETF Labels

There are at least 49 different Large Cap Value ETFs and at least 236 ETFs across all style. Do investors need that many choices? How different can the ETFs be?

Those 49 Large Cap Value ETFs are very different. With anywhere from 19 to 1403 holdings, many of these Large Cap Value ETFs have drastically different portfolios, creating drastically different investment implications.

The same is true for the ETFs in any other style, as each offers a very different mix of good and bad stocks. Some styles have lots of good stocks and offer quality funds. The opposite is true for some styles, while others lie in between these extremes with a fair mix of good and bad stocks. For example, the Large Cap Value style, per my 2Q Style Rankings Report ranks second out of 12 styles when it comes to providing investors with quality ETFs. Large Cap Blend ranks first. Small Cap Value ranks last. Details on the Best & Worst ETFs in each style are here.

The bottom line is: ETF labels do not tell you the kind of stocks you are getting in any given ETF.

Paralysis By Analysis

I firmly believe ETFs for a given style should not all be that different. I think the large number of Large Cap Value (or any other) style of ETFs hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many ETFs. Analyzing ETFs, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each ETF. As stated above, that can be as many as 1403 stocks, and sometimes even more, for one ETF.

Any investor worth his salt recognizes that analyzing the holdings of an ETF is critical to finding the best ETF.

Figure 1: Best Style ETFs

Screen shot 2014-04-30 at 10.38.59 AMSources:   New Constructs, LLC and company filings

The Danger Within

Why do investors need to know the holdings of ETFs before they buy? They need to know to be sure they do not buy a fund that might blow up. Buying a fund 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. No matter how cheap, if it holds bad stocks, the ETF’s performance will be bad.


Finding the Style ETFs with the Best Holdings

Figure 1 shows my top rated ETF for each style. Importantly, my 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 we do for each stock we cover. Accordingly, our coverage of ETFs leverages the diligence we do on each stock by rating ETFs based on the aggregated ratings of the stocks each ETF holds.

Schwab US Dividend Equity ETF (SCHD) is the top-rated All Cap Blend ETF and the overall second-rated fund of the 236 style ETFs that I cover. Only the Large Cap Value style contains any Attractive (i.e. 4-star) rated ETFs, while the best every other style can offer is a Neutral or 3-star ETF.

Sometimes, you get what you pay for.

It is troubling to see one of the best style ETFs, First Trust First Trust Capital Strength ETF (FTCS) have just $77 million in assets despite its Attractive or 4 star rating. On the other hand, Dangerous-rated PowerShares S&P 500 High Dividend Portfolio (SPHD) has $158 million in assets. SPHD has lower total annual costs than FTCS (0.33% and 0.72% respectively), but low costs cannot drive positive performance. Quality holdings are the ultimate driver of performance.

I cannot help but wonder if investors would leave SPHD if they knew that it has such a poor portfolio of stocks. It is cheaper than FTCS, but, as previously stated, low fees cannot growth wealth; only good stocks can.

Sometimes, you DON’T get what you pay for.

The smallest ETF in Figure 1 is State Street SPDR Russell 2000 Low Volatility ETF (SMLV) with just $11 miilion in assets. Sadly, other Small Cap Blend ETFs with more assets and inferior portfolios charge more than SMLV. In other words, Small Cap Blend ETF investors are paying extra fees for no reason.

First Trust Small Cap Core AlphaDEX Fund (FYX) is one of the worst ETFs in the Small Cap Blend style. It gets my Dangerous rating based off the fact that barely 8% of its assets are allocated to Attractive-or-better rated stocks, while 67% is allocated to Dangerous-or-worse stocks. FYX also has total annual costs of 0.78%, higher than SMLV’s 0.28%. One would think that FYX would have fewer assets than SMLV, but instead it has over $566 million. Investors are paying extra fees for poor holdings.

The worst ETF in Figure 1 is Vanguard S&P Small-Cap 600 Growth ETF (VIOG), which gets a Dangerous (2-star) rating. One would think ETF providers could do better for this style.

I recommend investors only buy ETFs with more than $100 million in assets. You can find more liquid alternatives for the other funds on my ETF screener.

Covering All The Bases, Including Costs

My ETF rating also takes into account the total annual costs, which represents the all-in cost of being in the ETF. This analysis is complex for mutual funds, but straightforward for ETFs, where all costs are factored into the expense ratio. While costs play a smaller role than holdings, my ratings penalize those ETFs with abnormally high costs.

Top Stocks Make Up Top ETFs

International Business Machines (IBM) is one of my favorite stocks held by FTCS and earns my Very Attractive rating. The declining PC market hurt IBM’s profits in 2013 as after-tax profit (NOPAT) declined by 3%, but company’s long-term track record of profit growth is solid. Over the past decade, IBM has grown NOPAT by 8% compounded annually. Its return on invested capital (ROIC) stands at a top quintile 15%. The market is focused on the near-term issues, however, as IBM is priced for stagnation. At its current valuation of ~$195/share, IBM has a price to economic book value ratio of 1.0, which implies that the company will never grow NOPAT from its current level. Given IBM’s track record of growth and adaptation, I expect it to easily surpass those low expectations.

Kyle Guske II contributed to this post.

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

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