How To Avoid The Worst Style ETFs 4Q22

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. More reliable & proprietary fundamental data drives my research and analysis of ETF holdings and provides investors with a new source of alpha. I leverage this 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 699 U.S. equity Style ETFs my firm covers. The weighted average is lower at 0.13%, 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 U.S. Equity ETF (BBUSBBUS
) is the least expensive.

Figure 1: 5 Most and Least Expensive Style ETFs

Investors need not pay high fees for quality holdings. iShares Morningstar Value ETF (ILCV) is the best ranked style ETF with low costs. ILCV’s Neutral Portfolio Management rating and 0.04% total annual cost earns it a very attractive rating. First Trust SMID Cap Rising Dividend Achievers ETF (SDVYDVY
SDVY
) is the best ranked style ETF overall that meets my liquidity minimums. SDVY’s attractive Portfolio Management rating and 0.66% total annual cost also earns 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

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

EA Series Generation Z ETF (ZGEN) is the worst rated ETF in Figure 2. SoFi Be Your Own Boss ETF (BYOB), Hoya Capital High Dividend Yield ETF (RIET), and Alger Mid Cap 40 ETF (FRTY) 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 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 ETFs HOLDINGs – FEESEES
= PERFORMANCE OF ETF

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