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This article explains how I determine the best ETFs in the 25 reports I publish each quarter on the best and worst ETFs and mutual funds by sector and style. Here is the Q4 "best and worst" preview. I follow these steps:

  1. Eliminate ETFs with inadequate (less than $100 million) assets and too much tracking error
  2. Determine which remaining ETFs are the best

There are several simple and free screens to perform the first step and cull out the ETFs that should be avoided. As long as you focus on ETFs from issuers that have a market cap of at least $100 million, you are likely working with ETFs that are successful enough to garner serious assets. So, you can assume their tracking error is respectable and liquidity is high enough that you will not get thrown under the bus by the bid/ask spread.

Now comes the hard part: picking the ETF with the best holdings. Contrary to the screens above, there are very few services that evaluate the quality of the holdings of an ETF. Research on holdings is necessary in your due diligence because an ETF's performance is only as good as its holdings' performance. No matter how cheap it is, if it holds bad stocks, the ETF's performance will be bad.

Performance of ETF's Holdings = Performance of ETF

You cannot rely on the ETF label/name to accurately reflect the ETF's holdings. ETFs with the same label often have radically different holdings. (See Barron's "The Danger Within.")

My ratings on ETFs are based primarily on my stock ratings of their holdings. Figure 1 below shows my ranking of the 10 best healthcare ETFs with assets over $100 million. Here are my rankings on all 21 U.S. equity healthcare ETFs.

I only recommend the top three ETFs in this sector: Health Care Select Sector SPDR (NYSEARCA:XLV), iShares Dow Jones U.S. Health Care Index Fund (NYSEARCA:IYH), and Vanguard Health Care ETF (NYSEARCA:VHT) because they get my four-star or better rating. I do not recommend investors buy any ETFs with a three-star rating or lower.

Figure 1: Top 10 Healthcare ETFs

Source: New Constructs, LLC and company filings.

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.

Figure 2 below shows my ranking of the 10 best large-cap value ETFs with a market cap over $100 million based on the quality of their holdings. Here are my rankings on all 39 U.S. equity large-cap value ETFs.

Figure 2: Top 10 Large-Cap Value ETFs

Source: New Constructs, LLC and company filings.

The best large-cap value ETF is WisdomTree Dividend ex-Financials Fund (NYSEARCA:DTN). Only two other ETFs in this sector -- iShares High Dividend Equity Fund (NYSEARCA:HDV) and PowerShares Dynamic LargeCap Value (NYSEARCA:PWV) -- earn my four-star, or Attractive, rating. All the rest get my three-star, or Neutral, rating and should be avoided.

The stock that shows up consistently in the top healthcare and large-cap value ETFs is Johnson & Johnson (NYSE:JNJ). This stock gets my Very Attractive rating. JNJ has a return on invested capital (ROIC) of 17%, which places it in the top quintile of all companies. Usually that kind of profitability comes at a price. In this case, the valuation of JNJ's stock price implies the company's profits will permanently decline by 26%. XLV's large allocation to a highly profitable, yet undervalued, stock exemplifies why XLV is one of the few ETFs that gets a Very Attractive rating.

Another stock that shows up often in the top healthcare and large-cap value ETFs is Verizon (NYSE:VZ). VZ's ROIC is not super high, but its economic earnings growth in its last fiscal year was nearly 100% vs. negative growth in reported accounting earnings. And the valuation of the stock is cheap. Its current stock price (~$46.50/share) implies the company's profits will permanently decline by about 30%. High profit growth and low valuation create excellent risk/reward in a stock.

Disclosure: I am long JNJ, VZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: How To Find The Best ETFs