How To Avoid The Worst Style 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 reliable and proprietary data 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 is to compare what cheap means.

To ensure you’re paying average or lower fees, only invest in ETFs with a total annual expense below 0.46% — the average annual total expense of the 689 US equity-style ETFs covered by my firm. The weighted average is lower at 0.13%, showing how investors tend to allocate their money to low-fee ETFs.

Figure 1 shows Emle’s Alpha Opportunities ETF (EOPS) is the most expensive style ETF and JPMorgan BetaBuilder’s US Equity ETF BBUS
is cheapest. State Road (SPGL, SPTM
ETFs are among the cheapest.

Figure 1: 5 most expensive and cheapest style ETFs

Investors don’t have to pay high fees for quality stocks. iShares Morningstar Value ETF (ILCV) is the top-rated, low-cost style ETF. ILVC’s attractive portfolio management rating and total annual expense of 0.04% give ILVC a very attractive rating. Alpha Architect US Quantitative Value ETF QVAL
is the top-rated style ETF overall that meets liquidity requirements. QVAL’s very attractive portfolio management rating and total annual expense of 0.54% also give it a very attractive rating.

On the other hand, the iShares Morningstar Small Cap Growth ETF (ISCG) holds bad stocks and gets a very unattractive rating despite a low annual total expense of 0.07%. 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 style with the worst portfolio management ratings, a function of fund holdings.

Figure 2: Style ETFs with the worst holdings

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

Roundhill MEME ETF (MEME) is the worst-rated ETF in Figure 2. Tidal SoFi Gig Economy ETF GIGE
Invesco S&P Small Cap High Dividend Low Volatility ETF XSHD
Nuveen Small Cap Select ETF (NSCS), iShares Morningstar Small Cap Growth ETF (ISCG), and IndexIQ US Mid Cap R&D Leaders ETF (MRND) also get a very unattractive overall forecast rating, meaning they not only hold bad stocks, they charge high total annual costs.

The inner danger

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business model and financials. In other words, researching ETF holdings is a 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 paid to write about specific stocks, styles, or topics.