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How To Avoid the Worst Sector ETFs

Tuesday, December 18th, 2012

Picking from the multitude of sector ETFs is a daunting task. In any given sector there may be as many as 50 different ETFs. There are at least 177 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 Find the Best Sector ETFs is here.

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.

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 0.55%, which is the average expense ratio of the 177 US equity ETFs I cover. Weighting the expense ratios by assets under management, the average expense ratio is lower at 0.32%. 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 total annual costs. ProShares provides all five of the most expensive ETFs while SPDR ETFs are among the cheapest.

Figure 1: Most & Least Expensive ETFs

Sources:   New Constructs, LLC and company filings

Proshares Ultra Health Care (RXL) and ProShare Ultra Consumer Goods (UGE) are the two most expensive US equity ETFs I cover. Schwab U.S. REIT (SCHH) and Vanguard REIT (VNQ) are the least expensive. Ironically, RXL and UGE are also the best-rated ETFs in Figure 1 while the cheapest ETFs receive my worst 1-Star or Very Dangerous Rating. RXL and UGE earn good ratings because the quality of their holdings is strong enough to justify a higher cost. 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 portfolio management ratings. The sectors are listed in descending order by overall rating as detailed in my 4Q Sector Ratings report.

Figure 2: Sector ETFs With Worst Holdings

Sources:   New Constructs, LLC and company filings

My overall ratings on ETFs are based primarily on my stock ratings of their holdings. My firm covers over 3000 stocks and is known for the due diligence done on each stock we cover.

PowerShares’ ETFs appear more often than any other provider in Figure 2, which means they offer the most ETFs with the worst holdings. Powershares S&P SmallCap (PSCC) has the worst holdings of all consumer staples ETFs. PowerShares Lux Nanotech (PXN), PowerShares S&P SmallCap Industrials (PSCI), PowerShares S&P SmallCap Energy (PSCE), and PowerShares S&P SmallCap Materials (PSCM) have the worst holdings of all ETFs in their sectors.

Note that no ETFs with a dangerous portfolio management rating 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 the cheapest ETF, SCHH, gets my worst rating because its holdings get my very dangerous rating. Similarly, Utilities Select Sector SPDR (XLU), 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 ETF screener. More analysis of the Best Sector ETFs is here.

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 Danger Within. 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

Simon Property Group (SPG) is one of worst stocks I cover. It is the top holding (12% of assets) of SCHH. SPG earns my Very Dangerous rating. SPG has misleading earnings – its economic earnings are negative and declining while its reports accounting earnings are positive and increasing. During the 14 years in my model, the company has never generated positive economic earnings. Not only is SPG not profitable, it is also overvalued. To justify its current stock price (~$155), the company must increase profits by 12.3% compounded annually for 20 years. That is a lot of future value creation for a company that has never created value. Investors should avoid this stock.

Johnson & Johnson (JNJ) is one of favorite holdings in RXL, one of two ETFs in Figure 1 to get my 4-star rating. This stock gets my Very Attractive rating. JNJ has a return on invested capital (ROIC) of 17%, which places it in the top quintile of all companies. Usually that kind of profitability comes at a price. In this case, the valuation of JNJ’s stock price implies the company’s profits will permanently decline by over 25%. RXL’s large allocation (12%) to a highly profitable, yet undervalued stock, exemplifies why RXL is one of the few ETFs that gets an Attractive or 4 star rating.

Disclosure: I own JNJ. I receive no compensation to write about any specific stock, sector or theme.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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