How To Avoid The Worst Sector ETFs 3Q22

Question: Why are there so many ETFs?

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

The large number of ETFs has little to do with serving your best interests as an investor. I leverage proprietary fundamental 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 0.49% – the average total annual costs of the 291 U.S. equity Sector ETFs my firm covers. The weighted average is lower at 0.25%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows InfraCap MLP ETF (AMZA) is the most expensive sector ETF and Schwab U.S. REIT ETF SCHH
is the least expensive. Simplify (VCAR, VCLO) provides two of the most expensive ETFs while Fidelity (FNCL
, FMAT
, FSTA) 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 Financials Index ETF (FNCL) is the best ranked sector ETF in Figure 1. FNCL’s neutral Portfolio Management rating and 0.09% total annual cost earns it a very attractive rating. First Trust Materials AlphaDEX Fund FXZ
is the best ranked sector ETF overall that meets my liquidity minimums. FXZ’s very attractive Portfolio Management rating and 0.71% total annual cost also earns it a very attractive rating.

On the other hand, Schwab U.S. REIT ETF (SCHH) holds poor stocks and earns a very unattractive rating, despite having low total annual costs of 0.08%. No matter how cheap an ETF looks, if it holds bad stocks, its performance will be bad. The quality of an ETF’s holdings matters more than its management fee.

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

State Street and Invesco IVZ
appear more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings.

ProShares Online Retail ETF ONLN
is the worst rated ETF in Figure 2. State Street SPDR S&P Health Care Equipment ETF XHE
, Tidal Home Appreciation U.S. REIT ETF (HAUS), Fidelity Cloud Computing ETF (FCLD), Invesco S&P Small Cap Utilities & Communication Services ETF PSCU
, and State Street SPDR S&P Aerospace & Defense ETF XAR
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 OF ETFs HOLDINGs – FEES = PERFORMANCE OF ETF

Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Brian Pellegrini receive no compensation to write about any specific stock, sector, or theme.