Question: Why are there so many ETFs?
Answer: ETF issuance is profitable, so Wall Street keeps creating more products to sell.
The large number of ETFs has little to do with serving your best interests as an investor. More reliable & proprietary fundamental data, proven in The Journal of Financial Economics, drives our research and analysis of ETF holdings and provides investors with a new source of alpha. We leverage this data to identify three red flags you can use to avoid the worst ETFs:
1. Inadequate Liquidity
This issue is the easiest 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. Small ETFs also generally have lower trading volume, which translates to higher trading costs via larger bid-ask spreads.
2. High Fees
ETFs should be cheap, but not all of them are. The first step here is to benchmark what cheap means.
To ensure you are paying average or below average fees, invest only in ETFs with total annual costs below 0.51%, the average total annual costs of the 287 U.S. equity Sector ETFs we cover. The weighted average is lower at 0.24%, which highlights how investors tend to put their money in ETFs with low fees.
Figure 1 shows ETFis Series Trust InfraCap MLP ETF (AMZA) is the most expensive sector ETF and Schwab U.S. REIT ETF (SCHH) is the least expensive. AdvisorShares (BEDZ, EATS) provides two of the most expensive ETFs while Fidelity (FENY, FSTA, FNCL) ETFs are among the cheapest.
Figure 1: 5 Most and Least Expensive Sector ETFs
Sources: New Constructs, LLC and company filings
Investors need not pay high fees for quality holdings.[1] Fidelity MSCI Energy Index ETF (FENY) is the best ranked sector ETF in Figure 1. FENY’s Neutral Portfolio Management rating and 0.09% total annual cost earns it a Very Attractive rating.[2] VanEck Steel ETF (SLX) is the best ranked sector ETF overall. SLX’s Very Attractive Portfolio Management rating and 0.61% total annual cost also earns it a Very Attractive rating.
Despite having low total annual costs of 0.08%, Schwab U.S. REIT ETF (SCHH) holds poor stocks and earns our Very Unattractive rating. No matter how cheap an ETF looks, if it holds bad stocks, its performance will be bad.
3. Poor Holdings
An ETF’s holding have more weight in determining overall performance than its costs. Therefore, avoiding poor holdings is the most important (and hardest) part of avoiding bad ETFs. Figure 2 shows the ETFs within each sector with the worst holdings or portfolio management ratings.
Figure 2: Sector ETFs with the Worst Holdings
Sources: New Constructs, LLC and company filings
Invesco (PSCM, PSCC, PXJ, PSCF) appears more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings.
Tidal Residential REIT Income ETF (HAUS) is the worst rated ETF in Figure 2 based on our predictive overall rating. State Street SPDR S&P Internet ETF (XWEB), State Street SPDR S&P Health Care Equipment ETF (XHE), ProShares Online Retail ETF (ONLN), U.S. Global Jets ETF (JETS), Fidelity MSCI Utilities Index ETF (FUTY), and Invesco Dynamic Oil & Gas Services ETF (PXJ) also earn a Very Unattractive predictive overall rating, which means not only do they hold poor stocks, but they also charge high total annual costs.
Our overall ratings on ETFs reflect out stock ratings of their holdings and the total annual costs of investing in the ETF.
The Danger Within
Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. To put it differently, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings. Don’t just take our word for it, see what Barron’s says on this matter.
PERFORMANCE OF ETF’s HOLDINGS – FEES = PERFORMANCE OF ETF
Analyzing each holding within funds is no small task. Our Robo-Analyst technology enables us to perform this diligence at scale and provide the research needed to fulfill the fiduciary duty of care. More of the biggest names in the financial industry (see At BlackRock, Machines Are Rising Over Managers to Pick Stocks) are now leveraging technology in the investment research process. Technology may be the only solution to the dual mandate for research: cut costs and fulfill the fiduciary duty of care. Investors, clients, advisors, and analysts deserve the latest technology to get the diligence required to make prudent investment decisions.
This article was originally published on February 10, 2023.
Disclosure: David Trainer, Kyle Guske II, and Italo Mendonça receive no compensation to write about any specific stock, sector, or theme.
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[1] Three independent studies from respected institutions prove the superiority of our data, models, and ratings. Learn more here.
[2] Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.