How To Avoid The Worst Sector ETFs 1Q23

Question: Why are there so many ETFs?

Answer: ETF issuance is profitable, so Wall Street keeps creating more products to sell.

I leverage my firm’s data to identify three red flags you can use to avoid the worst ETFs:

1. Inadequate Liquidity

This issue is the easiest 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. Small ETFs also generally have lower trading volume, which translates to higher trading costs via larger bid-ask spreads.

2. High Fees

ETFs should be cheap, but not all of them are. The first step here is to benchmark what cheap means.

To ensure you are paying average or below average fees, invest only in ETFs with total annual costs below 0.51%, the average total annual costs of the 287 U.S. equity Sector ETFs my firm covers. The weighted average is lower at 0.24%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows ETFis Series Trust InfraCap MLP ETF (AMZA) is the most expensive sector ETF and Schwab U.S. REIT ETF SCHH
is the least expensive. AdvisorShares (BEDZ, EATS) provides two of the most expensive ETFs while Fidelity FENY
, FSTA,FNCL
ETFs are among the cheapest.

Figure 1: 5 Most and Least Expensive Sector ETFs

Investors need not pay high fees for quality holdings. Fidelity MSCI Energy Index ETF (FENY) is the best ranked sector ETF in Figure 1. FENY’s neutral Portfolio Management rating and 0.09% total annual cost earns it a very attractive rating. VanEck Steel ETF (SLX) is the best ranked sector ETF overall. SLX’s very attractive Portfolio Management rating and 0.61% total annual cost also earns it a very attractive rating.

Despite having low total annual costs of 0.08%, Schwab U.S. REIT ETF (SCHH) holds poor stocks and earns a very unattractive rating. No matter how cheap an ETF looks, if it holds bad stocks, its performance will be bad.

3. Poor Holdings

An ETF’s holding have more weight in determining overall performance than its costs. Therefore, avoiding poor holdings is the most important (and hardest) part of avoiding bad ETFs. Figure 2 shows the ETFs within each sector with the worst holdings or portfolio management ratings.

Figure 2: Sector ETFs with the Worst Holdings

Invesco (PSCM
, PSCC,PXJ
, PSCF) appears more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings.

Tidal Residential REIT Income ETF (HAUS) is the worst rated ETF in Figure 2 based on my predictive overall rating. State Street SPDR S&P Internet ETF XWEB
, State Street SPDR S&P Health Care Equipment ETF XHE
, ProShares Online Retail ETF ONLN
, U.S. Global Jets ETF JETS
, Fidelity MSCI Utilities Index ETF FUTY
, and Invesco Dynamic Oil & Gas Services ETF (PXJ) also earn a very unattractive predictive overall rating, which means not only do they hold poor stocks, but they also 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. To put it differently, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings.

PERFORMANCE OF ETF’s HOLDINGS – FEES = PERFORMANCE OF ETF

Disclosure: David Trainer, Kyle Guske II, and Italo Mendonça receive no compensation to write about any specific stock, sector, or theme.