3 Red Flags to Avoid the Worst ETFs

ETF Investing
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Why are there so many ETFs? The answer is: because ETF providers are making lots of money selling them. The number of ETFs has little to do with serving investors’ best interests.

Here are three red flags investors can use to avoid the worst ETFs:

  1. Inadequate Liquidity
    This is the easiest issue to avoid, and my 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. In addition, low asset levels tend to mean lower volume in the ETF and large 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 0.50%, which is the average total annual cost of the 274 U.S. equity ETFs I cover.

Figure 1 shows the most and least expensive style ETFs in the U.S. equity universe based on total annual costs. QuantShares provides three of the most expensive style ETFs while Schwab ETFs are among the cheapest.

Figure 1: 5 Least and Most-Expensive Style ETFs

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Sources: New Constructs, LLC and company filings

However, investors need not pay high fees for good holdings. Schwab U.S. Dividend Equity ETF (SCHD) is my second rated style ETF and earns my Very Attractive rating. It also has low total annual costs of only 0.08%.

  1. Poor Holdings
    Avoiding poor holdings is by far the hardest step to finding the best 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 style with the worst holdings or portfolio management ratings.

There are no ETFs in the All Cap Growth or All Cap Value styles.

Figure 2: Style ETFs with the Worst Holdings

Style ETFs with the Worst Holdings

Sources: New Constructs, LLC and company filings

Vanguard appears more often than any other providers in Figure 2, which means that they offer the most style ETFs with the worst holdings.

My overall ratings on ETFs are based primarily on my stock ratings of their holdings. New Constructs covers over 3000 stocks and is known for the due diligence done on each stock we cover.

Beware of the Danger Within

With ETF investing, 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.

PERFORMANCE OF ETF’s HOLDINGs = PERFORMANCE OF ETF

 

New Constructs reviews thousands of SEC filings, so you don’t have to. We calculate Price-to-EBV ratios for over 3,000 companies. Get access to them all by starting your membership today.

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Kyle Guske II contributed to this article

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

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