Picking from the multitude of sector ETFs is a daunting task. In any given sector, there may be as many as 50 different ETFs. There are at least 177 ETFs across all sectors.
Why are there so many ETFs? The answer is: because ETF providers are making a lot of money selling them. The number of ETFs has little to do with serving investors' best interests. Below are three red flags investors can use to avoid the worst ETFs:
- Inadequate liquidity
- High fees
- Poor quality holdings
I address these red flags in order of difficulty. Advice on How to Find the Best Sector ETFs is here.
How To Avoid ETFs with Inadequate Liquidity
This is the easiest issue to avoid and my advice is simple. Avoid all ETFs with less than $100 million in assets.
How To Avoid 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 an expense ratio below 0.55%, which is the average expense ratio of the 177 U.S. equity ETFs I cover. Weighting the expense ratios by assets under management, the average expense ratio is lower at 0.32%. A lower weighted average is a good sign that investors are putting money in the cheaper ETFs.
Figure 1 shows the most and least expensive sector ETFs in the U.S. equity universe based on total annual costs. ProShares provides all five of the most expensive ETFs while SPDR ETFs are among the cheapest.
Figure 1: Most & Least Expensive ETFs
Sources: New Constructs, LLC and company filings
Proshares Ultra Health Care (NYSEARCA:RXL) and ProShare Ultra Consumer Goods (NYSEARCA:UGE) are the two most expensive U.S. equity ETFs I cover. Schwab U.S. REIT (NYSEARCA:SCHH) and Vanguard REIT (NYSEARCA:VNQ) are the least expensive. Ironically, RXL and UGE are also the best-rated ETFs in Figure 1 while the cheapest ETFs receive my worst 1-Star or Very Dangerous Rating. RXL and UGE earn good ratings because the quality of their holdings is strong enough to justify a higher cost. On the other hand, SCHH and VNQ hold poor stocks. And no matter how cheap an ETF, if it holds bad stocks, its performance will be bad.
This result highlights why investors should not choose ETFs based only on price. The quality of holdings matters more than price.
How To Avoid ETFs with the Worst Holdings
This step is by far the hardest, 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 sector with the worst holdings or portfolio management ratings. The sectors are listed in descending order by overall rating as detailed in my 4Q Sector Rankings report.
Figure 2: Sector ETFs With Worst Holdings
Sources: New Constructs, LLC and company filings
PowerShares' ETFs appear more often than any other provider in Figure 2, which means they offer the most ETFs with the worst holdings. Powershares S&P SmallCap (NASDAQ:PSCC) has the worst holdings of all consumer staples ETFs. PowerShares Lux Nanotech (NYSEARCA:PXN), PowerShares S&P SmallCap Industrials (NASDAQ:PSCI), PowerShares S&P SmallCap Energy (NASDAQ:PSCE), and PowerShares S&P SmallCap Materials (NASDAQ:PSCM) have the worst holdings of all ETFs in their sectors.
Note that no ETFs with a dangerous portfolio management rating earn an overall rating better than two stars. These scores are consistent with my belief that the quality of an ETF is more about its holdings than its costs. If the ETF's holdings are dangerous, then the overall rating cannot be better than dangerous because one cannot expect the performance of the ETF to be any better than the performance of its holdings.
Figure 2 reveals that the cheapest ETF, SCHH, gets my worst rating because its holdings get my very dangerous rating. Similarly, Utilities Select Sector SPDR (NYSEARCA:XLU), also one of the cheapest ETFs, gets a dangerous portfolio management rating and, therefore, cannot earn anything better than a 2-star or dangerous overall rating. Again, the ETF's overall rating cannot be any better than the rating of its holdings.
The Danger Within
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. 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
Best & Worst Stocks In these ETFs
Simon Property Group (NYSE:SPG) is one of worst stocks I cover. It is the top holding (12% of assets) of SCHH. SPG earns my Very Dangerous rating. SPG has misleading earnings - its economic earnings are negative and declining while its reports accounting earnings are positive and increasing. During the 14 years in my model, the company has never generated positive economic earnings. Not only is SPG not profitable, it is also overvalued. To justify its current stock price (~$155), the company must increase profits by 12.3% compounded annually for 20 years. That is a lot of future value creation for a company that has never created value. Investors should avoid this stock.
Johnson & Johnson (NYSE:JNJ) is one of favorite holdings in RXL, one of two ETFs in Figure 1 to get my 4-star rating. 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 over 25%. RXL's large allocation (12%) to a highly profitable, yet undervalued stock, exemplifies why RXL is one of the few ETFs that gets an Attractive or 4 star rating.
Disclosure: I am long JNJ. 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.
Disclaimer: I receive no compensation to write about any specific stock, sector or theme.