Picking from the multitude of sector ETFs is a daunting task. In any given sector there may be as many as 43 different ETFs, and there are at least 171 ETFs across all sectors.
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. Below are three red flags investors can use to avoid the worst ETFs:
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. 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.
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 171 US equity ETFs I cover. Weighting the expense ratios by assets under management, the average expense ratio is lower at 0.31%. 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 US equity universe based on total annual costs. ProShares provides all five of the most expensive ETFs while Vanguard Group ETFs are among the cheapest.
Figure 1: 5 Least and Most-Expensive Sector ETFs
Sources: New Constructs, LLC and company filings
Proshares Ultra Consumer Goods (UGE) and ProShares Ultra Technology (ROM) are the two most expensive U.S. equity ETFs I cover, while Schwab U.S. REIT (SCHH) and Vanguard REIT (VNQ) are the least expensive. Ironically, the more expensive RXL and UGE are also some of the best-rated ETFs in Figure 1 while the cheapest ETFs receive my 2-Star or Dangerous Rating. RXL and UGE earn good ratings because the quality of their holdings is strong despite their higher costs.
However, investors need not pay high fees for good holdings. Vanguard Consumer Staples ETF (VDC) is my highest rated ETF and one of only seven to get an Attractive (4-star) rating, yet it has a low total annual cost of 0.15%. In addition, Vanguard Information Tech (VGT), the fourth cheapest ETF available, is also my third highest rated ETF.
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 2Q Sector Ratings report.
Figure 2: Sector ETFs with the Worst Holdings
Sources: New Constructs, LLC and company filings
iShares and PowerShares ETFs appear more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings. iShares FTSE NAREIT Industrial/Office Capped Index Fund (FNIO) has the worst holdings of all Financials ETFs. PowerShares S&P SmallCap Consumer Staples Portfolio (PSCC), PowerShares Lux Nanotech Portfolio (PXN), iShares Dow Jones U.S. Home Construction Index Fund (ITB), iShares Dow Jones U.S. Telecommunications Index Fund (IYZ) and PowerShares S&P SmallCap Utilities Portfolio (PSCU) all have the worst holdings in their respective 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 one of the cheapest ETFs, PSCC, gets a Dangerous rating because its holdings get my Dangerous rating. Similarly, PowerShares S&P SmallCap Utilities Portfolio , 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
Duke Realty Corp. (DRE) is one of my least favorite stocks held by FNIO and earns my Dangerous rating. In the fourteen years covered by my model, DRE has never earned positive economic earnings, and its return on invested capital (ROIC) has been declining since 2005. Not only is DRE not profitable, it is also overvalued. In order to justify its current stock price ~$18.65, the company must grow after tax profit (NOPAT) by 11% compounded annually for seven years. That is a tall order for a company whose NOPAT is at its lowest level in four years and on the decline.
IBM (IBM) is one of favorite holdings in VGT, one of two low-cost ETFs in Figure 1 to get my 4-star rating. This stock gets my Very Attractive rating. IBM has a return on invested capital (ROIC) of almost 16%, which places it in the top quintile of all companies I cover. Even though the PC industry as a whole appears to be on a downward trend, IBM has grown NOPAT by 10% compounded annually over the past five years. While such profitability usually translates to a high valuation, IBM's share price (~$208.44) gives it a price to economic book value ratio of 1.0. This valuation implies the company will never grow profits beyond 2012 levels. With such low expectations built into the stock price, investors get the opportunity for high returns with very little risk. The fact that IBM is one of VGT's top five holdings helps explain why VGT is one of the few ETFs to get my Attractive rating.
Sam McBride and André Rouillard contributed to this article
Disclosure: David Trainer, Sam McBride and André Rouillard receive no compensation to write about any specific stock, sector, or theme.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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).