How to Find the Best Style ETFs

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 45 different Large-cap Value ETFs and at least 228 ETFs across all styles. Do investors need that many choices? How different can the ETFs be?

Those 45 Large Cap Value ETFs are very different. With anywhere from 20 to 1,407 holdings, many of these large cap ETFs have drastically different portfolios, creating drastically different investment implications.

I am sure that Large Cap Value ETFs hold many of the same big stocks such as Exxon Mobil (XOM), Coca Cola (KO), and Wells Fargo (WFC). However, investors need to know what else those ETFs hold before they can say they have done their due diligence.

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, Large Cap Value, per my 4Q Style Rankings report, ranks second out of 12 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.

Still, the bottom line is: ETF labels do not tell you what kind of stocks you are getting in any given ETF.

Paralysis By Analysis

I firmly believe ETFs for a given style should not be all 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 1,407 stocks for one ETF.

Any investor worth his salt knows that knowing the holdings of an ETF is critical to finding the best ETF.

Figure 1: Best Style ETFs

Screen shot 2013-11-01 at 3.53.27 PMSources: 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 an ETF that is likely to perform poorly. Buying an ETF 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.

Schwab US Dividend Equity Fund (SCHD) is the top-rated All Cap Blend ETF and the top-rated ETF overall of the 228 style ETFs I cover. Only the Large Cap Blend, Large Cap Value and All Cap Blend styles contain any Attractive (i.e. 4-star) rated ETFs while the best every other style can offer is a Neutral or 3-star ETF, or even a Dangerous or 2-star ETF.

Sometimes, you get what you pay for.

It is troubling to see one of the best style ETFs, WisdomTree U.S. Dividend Growth Fund (DGRW), have just $66 million in assets. Meanwhile, Vanguard Dividend Appreciation Fund (VIG), another Large Cap Value fund, has over $18 billion in assets despite its Neutral rated portfolio. VIG’s expense ratio of 0.11% is lower than DGRW’s expense ratio of 0.31%, but as I state above, no matter how cheap an ETF, if it does not hold good stocks it will not perform well. Sometimes, you get what you pay for.

Another example of how you sometimes get what you pay for: iShares Russell Mid-Cap Value ETF (IWS). IWS has over $5 billion in assets despite getting a Dangerous (2-star) rating. Investors seem to be attracted to its low expense ratio of 0.34% with less regard for the quality of its holdings. Meanwhile, the top-rated Mid Cap Value ETF, WisdomTree MidCap Earnings Fund (EZM), has a 3-star rating but only $383 million in assets.

I cannot help but wonder if investors would leave IWS if they knew that it has such a poor portfolio of stocks. It is cheaper than EZM, but as previously stated, low fees cannot growth wealth; only good stocks can.

Sometimes, you DON’T get what you pay for.

One of the smaller ETFs in Figure 1 is Vanguard S&P Small-Cap 600 Growth ETF (VIOG) with just $34 million in assets. Sadly, other ETFs with more assets and similar portfolios (virtually identical top 5 holdings) charge more than VIOG. In other words, Small Cap Growth ETF investors are paying extra fees for no reason.

Specifically, at 0.28%, iShares S&P Small-Cap 600 Growth ETF (IJT) with $2.8 billion in assets and my Dangerous rating charges more than VIOG, which charges 0.22%. Both funds have the same top five holdings and virtually identical portfolios, so investors should not be paying extra fees for the same holdings.

The worst ETF in Figure 1 is Small Cap Blend’s WisdomTree U.S. SmallCap Dividend Growth Fund (DGRS), 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 simpler for ETFs than funds because they do not charge front- or back-end loads and transaction costs are incurred directly. There is only the expense ratio, which is normally quite low. However, my ratings penalize those ETFs with abnormally high expense ratios or any other hidden costs.

Top Stocks Make Up Top ETFs

3M Company (MMM) is one of my favorite stocks held by iShares Morningstar Large-Cap ETF (JKD) and earns my Attractive rating. MMM has grown after-tax profit (NOPAT) by 10% compounded annually over the past decade. MMM has a top-quintile ROIC of 18%, double the average of 9% among the nine other industrial conglomerates we cover. Add in the fact that MMM has been slowly but steadily expanding its margins over the past decade, and the company looks set up for long term success.

As Warren Buffet said, “A great business at a fair price is superior to a fair business at a great price,” and that applies for MMM. At its current valuation of ~$125/share, MMM has a price to economic book value ratio of 1.5, which is not expensive but not especially cheap either. That valuation implies that MMM will never grow its NOPAT by more than 50% from its present levels. For a company with the history of growth and profitability that MMM has, that is likely an overly pessimistic expectation. MMM is not the cheapest stock at the moment, but for a long-term investor it still has significant upside with low risk.

Sam McBride contributed to this post

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

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