Question: Why are there so many ETFs?
Answer: ETF providers tend to make lots of money on each ETF so they create more products to sell.
The large number of ETFs has little to do with serving your best interests. Below are three red flags you can use to avoid the worst ETFs:
1. Inadequate Liquidity
This issue is the easiest to avoid, and our 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. Plus, low asset levels tend to mean lower volume in the ETF and larger bid-ask spreads.
2. 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 average or below average fees, invest only in ETFs with total annual costs below 0.48%, which is the average total annual costs of the 180 U.S. equity Sector ETFs we cover. The weighted average is lower at 0.27%, which highlights how investors tend to put their money in ETFs with low fees.
Figure 1 shows PowerShares KBW High Dividend Yield Financial (KBWD) is the most expensive sector ETF and Schwab U.S. REIT ETF (SCHH) is the least expensive. PowerShares (KBWD) (PXE) provides two of the most expensive ETFs while Fidelity (FDIS) (FSTA) (FENY) (FNCL) ETFs are among the cheapest.
Figure 1: 5 Least and Most Expensive Sector ETFs
Investors need not pay high fees for quality holdings. Fidelity MSCI Consumer Staples Index (FSTA) is the best ranked sector ETF in Figure 1. FTSA’s Neutral Portfolio Management rating and 0.09% total annual cost earn it a Very Attractive fund rating. VanEck Vectors Mortgage REIT Income ETF (MORT) is the best ranked sector ETF overall. MORT’s Attractive Portfolio Management rating and 0.45% total annual cost also earn it a Very Attractive fund rating.
On the other hand, Schwab U.S. REIT ETF (SCHH) holds poor stocks and earns our Unattractive rating yet has low total annual costs of 0.08%. No matter how cheap an ETF, if it holds bad stocks, its performance will be bad. The quality of an ETFs holdings matters more than its price.
3. Poor Holdings
Avoiding poor holdings is by far the hardest part of avoiding bad 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 sector with the worst holdings or portfolio management ratings.
Figure 2: Sector ETFs with the Worst Holdings
PowerShares (PSCC) (KBWD) (PYZ) (PSR) (PSCU) appears more often than any other provider in Figure 2, which means that they offer the most ETFs with the worst holdings.
Sources: New Constructs, LLC and company filings
VanEck Oil Services ETF (OIH) is the worst rated ETF in Figure 2. ARK Innovation ETF (ARKK) and BioShares Biotechnology Products Fund (BBP) also earn a Very Unattractive predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs.
The Danger Within
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. Don’t just take our word for it, see what Barron’s says on this matter.
PERFORMANCE OF ETFs HOLDINGs = PERFORMANCE OF ETF
Analyzing each holding within funds is no small task. Our Robo-Analyst technology enables us to perform this diligence with scale and provide the research needed to fulfill the fiduciary duty of care. More of the biggest names in the financial industry (see At BlackRock, Machines Are Rising Over Managers to Pick Stocks) are now embracing technology to leverage machines in the investment research process. Technology may be the only solution to the dual mandate for research: cut costs and fulfill the fiduciary duty of care. Investors, clients, advisors and analysts deserve the latest in technology to get the diligence required to make prudent investment decisions.
This article originally published here on October 25, 2017.
Disclosure: David Trainer, Kenneth James, and Kyle Guske II receive no compensation to write about any specific stock, sector, or theme.
Disclosure: I/we 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.