How To Avoid the Worst Sector ETFs 3Q17

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 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 costs of the 175 U.S. equity Sector ETFs we cover. The weighted average is lower at 0.26%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows PowerShares KBW High Dividend Yield Financial (KBWD) is the most expensive sector ETF and Schwab U.S. REIT ETF (SCHH) is the least expensive. ETF Series Trust (UTES, BBP) provides two of the most expensive ETFs while Fidelity (FNCL, FSTA, FTEC, FUTY) ETFs are among the cheapest.

Figure 1: 5 Least and Most Expensive Sector ETFs

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings. Fidelity MSCI Financials Index (FNCL) earns our Very Attractive rating and has low total annual costs of only 0.09%.

On the other hand, Fidelity MSCI Energy Index ETF (FENY) holds poor stocks and earns our Very Unattractive rating, yet has low total annual costs of 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 ETF’s performance is determined more by its holdings than its costs. 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

PowerShares (PSCC, PSCU), iShares (ICF, IYZ), and State Street (XTN, XME) appear more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings.

BioShares Biotechnology Products Fund (BBP) is the worst rated ETF in Figure 2. ARK Innovation ETF (ARKK), iShares U.S. Telecommunications (IYZ), and VanEck Vectors Oil Services (OIH) also earn a Very Unattractive predictive overall rating, which means not only do they hold poor stocks, they 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.

PERFORMANCE OF ETFs HOLDINGs = PERFORMANCE OF ETF

Analyzing each holding within funds is no small task. Our Robo-Analyst technology enables us to perform this diligence with 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 embracing technology to leverage machines 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 in technology to get the diligence required to make prudent investment decisions.

This article originally published on August 3, 2017.

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

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