September 30, 2023

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Q: Why are there so many ETFs?

Answer: Issuing ETFs is profitable, so Wall Street keeps creating more products to sell.

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I leverage proprietary data to identify three red flags you can use to avoid the worst ETFs:

1. Insufficient Liquidity

Avoiding this problem is easiest, and my advice is simple. Avoid all ETFs with less than $100 million in assets. The low level of liquidity can create a discrepancy between the price of the ETF and the underlying value of the securities it holds. Smaller ETFs also typically have lower trading volumes, which translates into higher trading costs through larger bid-ask spreads.

2. High Fees

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

To ensure you’re paying at or below average fees, invest only in ETFs with total annual costs less than 0.46% The Average Total Annual Cost of 727 US Equity Style ETFs My Firm Covers The weighted average is low at 0.14%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows that the most expensive style ETF is the Convergence Long/Short Equity ETF (CLSE) and the JP Morgan Betabuilders US Equity ETF (BBUS)
) is the least expensive. Vanguard offers 2 of the cheapest ETFs in my analysis.

Figure 1: 5 Most and Least Expensive Style ETFs

Investors need not pay high fees for quality holdings. Vanguard Total Stock Market Index Fund (VTI
) is one of the best-ranked style ETFs in Figure 1. VTI’s neutral portfolio management rating and 0.03% aggregate annual cost make it an attractive rating. Direxion Daily Homebuilders & Supply Bull 3X Shares (NAIL) is the best-ranked style ETF overall. NAIL’s attractive portfolio management rating and 1.07% CAGR make it a very attractive rating.

3. poor holdings

Avoiding bad holdings is the hardest part of avoiding bad ETFs, but it’s also the most important because an ETF’s performance is determined more by its holdings than by its costs. Figure 2 shows the ETFs with the worst portfolio management ratings within each style, as a function of the fund’s holdings.

Figure 2: Style ETFs with Worst Holdings

Invesco appears more often than any other providers in Figure 2, meaning they offer the most ETFs with the worst holdings.

The Invesco Real Assets ESG ETF (IVRA) is the worst rated ETF in Figure 2. SoFi Be Your Own Boss (BYOB), IQ US Mid Cap R&D Leaders ETF (MRND), Motley Fool Small Cap Growth ETF (TMFS), Invesco S&P Small Cap High Dividend Low Volatility ETF (XSHD
), and the Roundhill MEME ETF (MEME) all earn a very unattractive predictive composite rating, which means that not only do they hold bad stocks, but they also charge high total annual costs.

threat from within

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business model and finances. Put another way, researching ETF holdings is necessary due diligence because the performance of an ETF is only as good as its holdings.

Performance of ETF Holdings – Fees
= ETF performance

Disclosure: David Trainor, Kyle Gaske II and Italo Mendonca do not receive any compensation for writing about any specific stock, style or theme.

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