How To Avoid The Worst Sector ETFs

Picking from the multitude of sector ETFs is a daunting task. In any given sector there may be as many as 45 different ETFs, and there are at least 183 ETFs across all sectors.

Why are there so many ETFs? The answer is: because ETF providers are making lots of money selling them. The number of ETFs has little to do with serving investors’ best interests. Below are three red flags investors can use to avoid the worst ETFs:

1. Inadequate liquidity
2. High fees
3. Poor quality holdings

I address these red flags in order of difficulty. Advice on .

How To Avoid ETFs with Inadequate Liquidity

This is the easiest issue to avoid, and my advice is simple. Avoid all ETFs with less than $100 million in assets. Low asset levels tend to mean lower volume in the ETF and large bid-ask spreads.

How To Avoid 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 an expense ratio below 0.52%, which is the average expense ratio of the 183 US equity ETFs I cover. Weighting the expense ratios by assets under management, the average expense ratio is lower at 0.33%. A lower weighted average is a good sign that investors are putting money in the cheaper ETFs.

Figure 1 shows the most and least expensive sector ETFs in the US equity universe based on FAS ), earns a better rating than three of the cheapest ETFs. Quality holdings can make up for high costs.

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However, investors need not pay high fees for good holdings. Fidelity MSCI Consumer Staples Index ETF (FSTA) is my highest rated sector ETF and earns my Attractive rating. It also has low total annual costs of only 0.13%.

On the other hand, SCHH and VNQ hold poor stocks. And no matter how cheap an ETF, if it holds bad stocks, its performance will be bad.

This result highlights why investors should not choose ETFs based only on price. The quality of holdings matters more than price.

How To Avoid ETFs with the Worst Holdings

This step is by far the hardest, but it is also the most important because an ETF’s performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each sector with the worst holdings or  .

My   of their holdings. My firm covers over 3000 stocks and is known for the due diligence done on each stock we cover.

iShares, PowerShares and SPDR ETFs appear more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings. iShares FTSE NAREIT Industrial/Office Capped Index Fund (PSCU ) all have the worst holdings in their respective sectors.

Note that no ETFs with a Dangerous   earn an overall rating better than two stars. These scores are consistent with my belief that the quality of an ETF is more about its holdings than its costs. If the ETF’s holdings are dangerous, then the overall rating cannot be better than dangerous because one cannot expect the performance of the ETF to be any better than the performance of its holdings.

Figure 2 reveals that one of the cheapest ETFs, PSCU, gets my Dangerous rating because its holdings get my Dangerous rating. Similarly, SPDR S&P Biotech ETF (XBI ), also one of the cheapest ETFs, gets a Dangerous portfolio management rating and, therefore, cannot earn anything better than a 2-star or Dangerous overall rating. Again, the ETF’s overall rating cannot be any better than the rating of its holdings.

Find the ETFs with the worst overall ratings on my  .

The Danger Within

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. As Barron’s says, investors should know the  . Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance.

PERFORMANCE OF ETF’s HOLDINGs = PERFORMANCE OF ETF

Best & Worst Stocks In these ETFs

Amazon.com Inc. ( , AMZN’s valuation implies an unrealistic level of profitability and growth. AMZN’s recent track record does not suggest it can achieve significant NOPAT growth. In 2013, AMZN’s NOPAT margin continued its decline to 0.7%, down from 1% the year before. At the current price of $361/share, the market expects AMZN to increase NOPAT by 26% compounded annually for 24 years. In the highly competitive arena of online retail this expectation seems highly unrealistic, especially when coupled with AMZN’s shrinking margins.

Chevron Corporation ( ) ratio of 0.75. This ratio implies that the market expects CVX’s NOPAT to permanently decline by 25%. With such pessimistic expectations and a strong history of growth, CVX presents a great opportunity for investors.

Kyle Guske II contributed to this article

Disclosure: David Trainer owns CVX. David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, or theme.

Written By: David Trainer