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:
- Inadequate Liquidity
This issue is the easiest issue 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.
- 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 total annual costs below 0.48%, which is the average total annual cost of the 298 U.S. equity Style ETFs we cover. The weighted average is slightly lower at 0.17%, which highlights how investors tend to put their money in ETFs with low fees.
Figure 1 shows that AdvisorShares Madrona Domestic ETF (NYSE:FWDD) is the most expensive style ETF and Schwab U.S. Large Cap (NYSE:SCHX) is the least expensive. Absolute Shares Trust (NYSE:WBIB, NYSE:WBID, NYSE:WBIC, and NYSE:WBIG) provides four of the most expensive ETFs while Schwab (SCHX and NYSE:SCHB) and Vanguard (NYSE:VOO and NYSE:VTI) ETFs are among the cheapest.
Figure 1: 5 Least and Most Expensive Style ETFs
Sources: New Constructs, LLC and company filings
Investors need not pay high fees for quality holdings. State Street SPDR S&P 500 (NYSE:SPY) Buyback ETF (NYSE:SPYB) earns our Very Attractive rating and has low total annual costs of only 0.39%.
On the other hand, a fund such as iShares Core U.S. Growth ETF (NYSE:IUSV) holds poor stocks. No matter how cheap an ETF (0.08% TAC), if it holds bad stocks, its performance will be bad. The quality of an ETFs holdings matters more than its price.
- Poor Holdings
Avoiding poor holdings is by far the hardest part of avoid bad ETFs, but it is also the most important because an ETFs performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each style with the worst holdings or portfolio management ratings.
Figure 2: Style ETFs with the Worst Holdings
Sources: New Constructs, LLC and company filings
PowerShares (NYSE:EQAL, NYSE:PXMV, and NYSE:EQWS) appears more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings.
ProShares Ultra Telecommunications (NYSE:LTL) is the worst rated ETF in Figure 2. PowerShares Russell MidCap Pure Value (NYSE:PXMV), PowerShares Russell 2000 Equal Weight (NYSE:EQWS), Vanguard Russell 2000 Growth Index (NASDAQ:VTWG), Global X Super Dividend U.S. (NYSE:DIV), and Guggenheim S&P Small Cap 600 Pure Value (NYSE:RZV) also earn a Dangerous predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs.
Our overall ratings on ETFs are based primarily on our stock ratings of their holdings.
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.
PERFORMANCE OF ETFs HOLDINGs = PERFORMANCE OF ETF
Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.