Question: Why are there so many ETFs?
Answer: ETF issuance is profitable, so Wall Street keeps cranking out 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 is to benchmark what cheap means.
To ensure you are paying at or below average fees, invest only in ETFs with total annual costs below 0.46%, the average total annual cost of the 727 U.S. equity Style ETFs we cover. The weighted average is lower at 0.14%, which highlights how investors tend to put their money in ETFs with low fees.
Figure 1 shows Convergence Long/Short Equity ETF (CLSE) is the most expensive style ETF and JPMorgan BetaBuilders US Equity ETF (BBUS) is the least expensive. Vanguard provides 2 of the cheapest ETFs in our analysis.
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. Vanguard Total Stock Market Index Fund (VTI) is one of the best ranked style ETFs in Figure 1. VTI’s Neutral Portfolio Management rating and 0.03% total annual cost earn it an Attractive rating. Direxion Daily Homebuilders and Supplies Bull 3X Shares (NAIL) is the best ranked style ETF overall. NAIL’s Attractive Portfolio Management rating and 1.07% total annual cost earn it a Very Attractive rating.
3. Poor Holdings
Avoiding poor holdings is by far the hardest part of avoiding 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 portfolio management ratings, a function of the fund’s holdings.
Figure 2: Style ETFs with the Worst Holdings
Sources: New Constructs, LLC and company filings
Invesco appears more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings.
Invesco Real Assets ESG ETF (IVRA) is the worst rated ETF in Figure 2. SoFi Be Your Own Boss (BYOB), IQ U.S. Mid Cap R&D Leaders ETF (MRND), Motley Fool Small Cap Growth ETF (TMFS), Invesco S&P Small Cap High Dividend Low Volatility ETF (XSHD), and Roundhill MEME ETF (MEME) all 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 our 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 model 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. 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 Mendonca receive no compensation to write about any specific stock, style, or theme.
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