How To Avoid The Worst Style ETFs 1Q23

Question: Why are there so many ETFs?

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

I leverage proprietary 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 is to benchmark what cheap means.

To ensure you are paying at or below average fees, invest only in ETFs with total annual costs below 0.46%, the average total annual cost of the 727 U.S. equity Style ETFs my firm covers. The weighted average is lower at 0.14%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows Convergence Long/Short Equity ETF (CLSE) is the most expensive style ETF and JPMorgan BetaBuilders US Equity ETF (BBUSBBUS
) is the least expensive. Vanguard provides 2 of the cheapest ETFs in my analysis.

Figure 1: 5 Most and Least Expensive Style ETFs

Investors need not pay high fees for quality holdings. Vanguard Total Stock Market Index Fund (VTIVTI
) is one of the best ranked style ETFs in Figure 1. VTI’s neutral Portfolio Management rating and 0.03% total annual cost earn it an attractive rating. Direxion Daily Homebuilders and Supplies Bull 3X Shares (NAIL) is the best ranked style ETF overall. NAIL’s attractive Portfolio Management rating and 1.07% total annual cost earn it a very attractive rating.

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 ETFs performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each style with the worst portfolio management ratings, a function of the fund’s holdings.

Figure 2: Style ETFs with the Worst Holdings

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

Invesco Real Assets ESG ETF (IVRA) is the worst rated ETF in Figure 2. SoFi Be Your Own Boss (BYOB), IQ U.S. Mid Cap R&D Leaders ETF (MRND), Motley Fool Small Cap Growth ETF (TMFS), Invesco S&P Small Cap High Dividend Low Volatility ETF (XSHDXSHD
), and Roundhill MEME ETF (MEME) all 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 model 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 ETF’s HOLDINGS – FEESEES
= PERFORMANCE OF ETF

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