How To Avoid The Worst Sector ETFs 3Q22

Question: Why are there so many ETFs?

Answer: Issuing ETFs is profitable, so Wall Street has more and more products for sale.

The large number of ETFs has little to do with serving your interests as an investor. I use proprietary fundamentals to identify three red flags you can use to avoid the worst ETFs:

1. Insufficient liquidity

This problem is the easiest to avoid, and my advice is simple. Avoid all ETFs with assets under $100 million. Low liquidity can lead to a discrepancy between the ETF’s price and the underlying value of the securities it holds. Small ETFs also generally have lower trading volume, which translates into higher trading costs via larger bid-offer spreads.

2. High fees

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

To ensure you’re paying average or below-average fees, only invest in ETFs with total annual expenses under 0.49% — the average annual total expenses of the 291 US stock sector ETFs my company covers. The weighted average is lower at 0.25%, showing how investors tend to put their money into low-fee ETFs.

Figure 1 shows that the most expensive sector ETF is the InfraCap MLP ETF (AMZA) and the Schwab US REIT ETF SCHH
is cheapest. Simplify (VCAR, VCLO) offers two of the most expensive ETFs, while Fidelity (FNCL
, FMAT
FSTA) ETFs are among the cheapest.

Figure 1: The 5 most expensive and cheapest sector ETFs

Investors don’t have to pay high fees for quality stocks. Fidelity MSCI Financials Index ETF (FNCL) is the top-rated sector ETF in Figure 1. FNCL’s neutral portfolio management rating and 0.09% total annual expense make it a very attractive valuation. First Trust Materials AlphaDEX fund FXZ
is the best rated sector ETF overall that meets my minimum liquidity requirement. FXZ’s very attractive portfolio management rating and total annual expense of 0.71% also give it a very attractive rating.

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

3. Bad stocks

Avoiding bad holdings is by far the hardest part of avoiding bad ETFs, but it’s also the most important, since an ETF’s performance is determined more by its holdings than its cost. Figure 2 shows the ETFs within each sector with the worst holdings or portfolio management ratings.

Figure 2: Industry ETFs with the worst holdings

State Street and Invesco IVZ
appear more frequently than any other provider in Figure 2, meaning they offer the most ETFs with the worst holdings.

ProShares Online Retail ETF ONLN
is the lowest-rated ETF in Figure 2. State Street SPDR S&P Health Care Equipment ETF XHE
Tidal Home Appreciation US 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 receive a very unattractive overall predictive rating, meaning that not only do they hold poor inventories, but they also charge high overall annual costs.

The inner danger

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. In other words, researching ETF holdings is necessary due diligence, as an ETF’s performance is only as good as its holdings.

ETF HOLDINGS PERFORMANCE – FEES = ETF PERFORMANCE

Disclosure: David Trainer, Kyle Guske II, Matt Shuler and Brian Pellegrini are not compensated to write about specific stocks, sectors or topics.