Finding the best ETFs is an increasingly difficult task in a world with so many ETFs to choose from.
You Cannot Trust ETF Labels
There are at least 38 different large cap value ETFs and at least 216 ETFs across all styles. Do investors need that many choices? How different can the ETFs be?
Those 38 large cap value ETFs are very different. With anywhere from 30 to 1,351 holdings, many of these ETFs have drastically different portfolios, which creates drastically different investment implications.
I am sure that large cap value ETFs hold many of the same big stocks such as International Business Machines (IBM), Chevron (CVX) and 3M (MMM). 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 style as each offers a very different mix of good and bad stocks. Some styles have lots of good stocks and offer lots of good ETFs. The opposite is true for others while some styles lie in between with a fair mix of good and bad stocks. For example, large cap value, per my 4Q Style Rankings report, ranks fourth 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.
The bottom line is that investors cannot trust ETF labels or names. They do not tell you what you are getting when you buy an ETF.
Paralysis By Analysis
I firmly believe ETFs for a given style should not all be 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 1,351 stocks for one ETF.
Any investor worth his salt knows that knowing the holdings of an ETF is critical to finding the best ETF.
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 might blow up. 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.
PERFORMANCE OF ETF's HOLDINGs = PERFORMANCE OF ETF
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 3000 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. Here is a sample ETF report.
PowerShares QQQ (QQQ) is not only the top-rated large cap growth ETF, it is the overall top-rated ETF of the 216 style ETFs 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.
Sometimes, you get what you pay for.
It is troubling to see one of the best style ETFs, PowerShares Buyback Achievers (PKW) have just $206 million in assets. The largest ETF in all cap blend, Vanguard Total Stock Market ETF (VTI), has nearly $24 billion in assets thought it only gets a Neutral (3-star) rating. VTI's expense ratio at 0.07% is much lower than PKW's at 0.66%, 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 to be sure you get what you pay for: PowerShares S&P 500 High Quality Portfolio (SPHQ) with a 4-star rating is the best large cap blend ETF but it only has $178 million in assets. iShares Core S&P 500 ETF (IVV) and SPDR S&P 500 (SPY) soak up the majority of the assets in that style even though they earn only 3-star ratings.
I cannot help to wonder if more investors would buy SPHQ is they knew it has a superior portfolio of stocks. It is more expensive than IVV and SPY, but as I have stated, low fees cannot growth wealth, only good stocks can.
Sometimes, you DON'T get what you pay for.
The smallest ETF in Figure 1 is Vanguard S&P Small-Cap 600 Growth ETF (VIOG) with just $14 million in assets. Sadly, other small cap growth 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%, both SPDR S&P 600 Small Cap Growth ETF (SLYG) with $161 million in assets and iShares S&P SmallCap 600 Growth Index Fund (IJT) with $1,579 million in assets charge more than VIOG, which charges 0.22%. Sometimes, you do not get what you pay for.
The worst ETF in Figure 1 is small cap blend's iShares Core S&P Small-Cap ETF (IJR), 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.
Figure 1: Best Style ETFs
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
One of my favorite holdings in SPHQ is Kellogg (K), which gets my Attractive (4 star) rating. This company earns the rare distinction of generating positive economic earnings every year since my model begins in 1998. Moreover, since 1998, Kellogg's economic earnings have grown over 260% or 8% compounded annually. That is a very steady cash-generating machine. However, the stock's valuation seems to overlook the company's profitable history. At ~$60/share, the current market valuation implies the company's cash flows (NOPAT) will permanently decline by 6%. A valuation that implies permanent profit decline and a history of strong profit generation make a nice risk/reward combination.
One of my favorite holdings in the Dow Jones Industrial Average ETF (DIA), one of four ETFs in Figure 1 to get my 4-star rating, is Exxon Mobil (XOM). In "Slow and Steady Wins the Race", I explain how XOM has created enormous value for shareholders over the last quarter century. Buying Exxon Mobil now is one of the easiest calls in the market these days. With superior cash flows, a cheap valuation and one of the strongest competitive positions in the business world, it is hard to make a straight-faced argument against owning this stock anywhere below $100. My model shows the stock is worth $140 if one assumes profits never grow from 2011 levels, i.e. the "no-growth" value of the stock. This stock offers nice risk/reward too.
Disclosure: I own XOM. I receive no compensation to write about any specific stock, style or theme.
Disclosure: I am long XOM. 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.
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David is CEO of New Constructs (www.newconstructs.com). David is a distinguished investment strategist and corporate finance expert. He was a 5-yr member of FASB's Investors Advisory Committee. He is author of the Chapter “Modern Tools for Valuation” in The Valuation Handbook (Wiley Finance 2010).