How To Avoid The Worst Style ETFs

ETFsDavid Trainer: Picking from the multitude of style ETFs is a daunting task. There are as many as 45 in any given style and at least 230 ETFs across all styles.

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 to overcome. Advice on How to Find the Best Style 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. Low levels of liquidity can lead to a discrepancy between the price of the ETF and the underlying value of the securities it holds. In addition, 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 measure what is cheap and expensive.

To ensure you are paying at or below average fees, invest only in ETFs with an expense ratio below 0.44%, which is the average total annual cost (TAC) of the 230 U.S. equity style ETFs I cover. Weighting the TAC by assets under management, the average expense ratio is lower at 0.19%. The lower weighted-average TAC is a good sign that investors are putting money in the cheaper ETFs.

Figure 1 shows the most and least expensive style ETFs in the US equity universe based on total annual costs. Advice on How to Avoid the Worst Sector ETFs is here.

Figure 1: Most and Least Expensive ETFs

Screen shot 2013-11-05 at 4.38.25 PM

Sources: New Constructs, LLC and company filings

AdvisorShares Madrona Forward Domestic ETF (FWDD) and AdvisorShares TrimTabs Float Shrink ETF (TTFS) are the two most expensive U.S. equity style ETFs I cover. Schwab U.S. Large-Cap ETF (SCHX) and Schwab U.S. Broad Market ETF (SCHB) are the two least expensive. In addition to being one of the five least expensive, Schwab U.S. Dividend Equity ETF (SCHD) has over $1.3 billion in assets and is my fourth-best ranked style ETF overall.

Interestingly, AdvisorShares TrimTabs Float Shrink ETF (TTFS), is the next highest rated ETF in Figure 1, ranking 17th among all the style ETFs I cover overall despite being among the five most expensive. TTFS holds one of the strongest portfolios among the ETFs that I cover.

These observations underscore why investors should not choose ETFs based only on price. The quality of holdings matters more than price in making an ETF attractive for investors.

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