How To Avoid the Worst Style ETFs 1Q18

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 at or below average fees, invest only in ETFs with total annual costs below 0.46%, which is the average total annual cost of the 446 U.S. equity Style ETFs we cover. The weighted average is lower at 0.15%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows WeatherStorm Forensic Accounting Long-Short ETF (FLAG) is the most expensive style ETF and Schwab U.S. Large Cap ETF (SCHX) is the least expensive. Direxion Shares (NAIL, DFEN) provide two of the most expensive ETFs while Schwab (SCHX, SCHB) and State Street (SPLG, SPTM) ETFs are among the cheapest.

Figure 1: 5 Most and Least Expensive Style ETFs

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings. Schwab U.S. Large Cap ETF (SCHX) is the best ranked style ETF in Figure 1. SCHX’s Neutral Portfolio Management rating and 0.03% total annual cost earns it a Very Attractive rating. Alpha Architect ValueShares U.S. Quantitative Value ETF (QVAL) is the best ranked style ETF overall. QVAL’s Attractive Portfolio Management rating and 0.88% total annual cost also earns it a Very Attractive rating.

On the other hand, State Street SPDR Portfolio S&P 500 Value ETF holds poor stocks and earns our Neutral rating, yet has low total annual costs of 0.04%. 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 avoid 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

Sources: New Constructs, LLC and company filings

ProShares (DIG, EQRR), Vanguard (VONV, VOT), State Street (SPYG, SPYD), Guggenheim (RYJ, RFV), and iShares (IWS, JKK) appear 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 and earns a Very Unattractive rating. Guggenheim Raymond James SB-1 Equity ETF (RYJ), Vanguard Mid Cap Growth Index (VOT), iShares Morningstar Small Cap Growth (JKK), PowerShares Russell 2000 Equal Weight Portfolio (EQWS), and Guggenheim S&P Mid Cap 400 Pure Value (RFV) earn an 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[1] 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 February 1, 2018.

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

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[1] Ernst & Young’s recent white paper “Getting ROIC Right” proves the superiority of our holdings research and analytics.

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