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 237 ETFs across all styles. Do investors need that many choices? How different can the ETFs be?

Those 49 Large Cap Value ETFs are very different. With anywhere from 18 to 1,412 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 1Q Style Rankings Report, ranks third out of 10 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 1,412 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 2014-02-11 at 9.09.50 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 3,000 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.

WisdomTree U.S. Dividend Growth Fund (DGRW) is the top-rated Large Cap Value ETF and the overall top-rated fund of the 237 style ETFs that I cover. It is concerning to see that only one style, Large Cap Value, contains any Attractive-or-better rated ETFs. Even more frightening is that in all of the 237 style ETFs, only three receive an Attractive-or-better rating. Investors seeking exposure to other styles should consider investing in individual stocks instead of ETFs.

Sometimes, you get what you pay for.

It is troubling to see one of the best Style ETFs, State Street SPDR MFS Systematic Growth Equity ETF (SYG) have just $5mm in assets despite its Neutral rating. On the other hand, Dangerous-rated iShares Morningstar Mid-Cap Value ETF (JKI) has $156mm in assets. JKI has lower total annual costs than SYG (0.33% and 0.66% 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 JKI if they knew that it has such a poor portfolio of stocks. It is cheaper than SYG, 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 MFS Systematic Growth Equity ETF (SYG) with just $5mm in assets. Sadly, other Large Cap Growth ETFs with more assets and inferior portfolios charge more than SYG. In other words, Large Cap Growth ETF investors are paying extra fees for no reason.

ProShares Ultra MidCap400 (MVV) is one of the worst ETFs in the Mid Cap Blend style. It gets my Dangerous rating based off the fact that barely 7% of its assets are allocated to Attractive-or-better rated stocks, while 52% is allocated to Dangerous-or-worse stocks. MVV also has total annual costs of 1.06%, higher than SYG’s 0.66%. One would think that MVV would have fewer assets than SYG, but instead it has over $150 million. Investors are paying extra fees for poor holdings.

The worst ETF in Figure 1 is iShares Russell 3000 Value ETF (IWW), 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 free 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 ETFs, as one has to consider not only expense ratios, but also front-end load and transaction fees. A high front-end load not only costs investors at the beginning, it also reduces the growth investors can experience later on. While costs play a smaller role than holdings, my ratings penalize those funds with abnormally high costs.

Top Stocks Make Up Top ETFs

National Health Investors, Inc. (NHI) is one of favorite holdings in DGRS and it earns my Attractive rating. Over the past decade, NHI has grown after-tax profits (NOPAT) by 11% compounded annually, for a total gain of about 300% over that time. NHI currently earns a top quintile return on invested capital (ROIC) of 21%, well above the 5% average of other hybrid REITs I cover. Despite this impressive growth and profitability, NHI’s stock price remained relatively flat over the last year. At its current valuation of ~$63/share, NHI has a price to economic book value (PEBV) ratio of 1.6. This ratio implies the market expects NHI to never grow NOPAT by more than 60% from its current level. Given the history of growth and rebound from the financial crisis, coupled with the outstanding profitability of NIH, those expectations seem rather pessimistic. If NHI can continue to grow NOPAT by 11% compounded annually for the next 15 years, the stock is worth ~$93/share today. Investors with a long-term view should look to NIH for a low risk, high reward investment.

Jared Melnyk contributed to this post.

Disclosure: David Trainer and Jared Melnyk receive no compensation to write about any specific stock, Style, or theme.

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