How To Avoid the Worst Style ETFs 3Q18

David Trainer  |

Question: Why are there so many ETFs?

Answer: ETF providers tend to make lots of money on each ETF so they create more products to sell.

The large number of ETFs has little to do with serving your best interests. Below are three red flags you can use to avoid the worst ETFs:

1. Inadequate Liquidity

This issue is the easiest issue to avoid, and our 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. Plus, low asset levels tend to mean lower volume in the ETF and larger bid-ask spreads.

2. High Fees

ETFs should be cheap, but not all of them are. The first step here is to know what is cheap and expensive.

To ensure you are paying at or below average fees, invest only in ETFs with total annual costs below 0.46%, which is the average total annual cost of the 463 U.S. equity Style ETFs we cover. The weighted average is lower at 0.15%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows FLAG Forensic Accounting Long-Short ETF (FLAG) is the most expensive style ETF and State Street SPDR Portfolio Large Cap ETF (SPLG) is the least expensive. AdvisorShares provides one of the most expensive ETFs while State Street (SPLG, SPTM) and Schwab (SCHX, SCHB) ETFs are among the cheapest.

Figure 1: 5 Most and Least Expensive Style ETFs

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings[1]. State Street SPDR Portfolio Large Cap ETF (SPLG) is the best ranked style ETF in Figure 1. SPLG’s Neutral Portfolio Management rating and 0.03% total annual cost earns it an Attractive rating[2]. Alpha Architect U.S. Quantitative Value ETF (QVAL) is the best ranked style ETF overall. QVAL’s Attractive Portfolio Management rating and 0.88% total annual cost earns it a Very Attractive rating.

On the other hand, Vanguard Small Cap Growth Index Fund (VBK) holds poor stocks and earns our Unattractive rating, yet has low total annual costs of 0.08%. No matter how cheap an ETF, if it holds bad stocks, its performance will be bad. The quality of an ETFs holdings matters more than its price.

3.Poor Holdings

Avoiding poor holdings is by far the hardest part of avoid 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 holdings or portfolio management ratings.

Figure 2: Style ETFs with the Worst Holdings

Sources: New Constructs, LLC and company filings

Invesco (RYJ, EQWS, RZV) and iShares (MTUM, IWS, JKK) appear more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings.

iShares Morningstar Small Cap Growth ETF (JKK) is the worst rated ETF in Figure 2. QUANTX Dynamic Beta U.S. Equity ETF (XUSA) also earns a Very Unattractive predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs.

Our overall ratings on ETFs are on our stock ratings of their holdings and the total annual costs of investing in the ETF.

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. Don’t just take our word for it, see what Barron’s says on this matter.

PERFORMANCE OF ETFs HOLDINGs = PERFORMANCE OF ETF

Analyzing each holding within funds is no small task. Our Robo-Analyst technology enables us to perform this diligence with scale and provide the research needed to fulfill the fiduciary duty of care. More of the biggest names in the financial industry (see At BlackRock, Machines Are Rising Over Managers to Pick Stocks) are now embracing technology to leverage machines in the investment research process. Technology may be the only solution to the dual mandate for research: cut costs and fulfill the fiduciary duty of care. Investors, clients, advisors and analysts deserve the latest in technology to get the diligence required to make prudent investment decisions.

This article originally published on July 30, 2018.

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

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[1] Ernst & Young’s recent white paper “Getting ROIC Right” proves the superiority of our holdings research and analytics.

[2] Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.

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


The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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