The Intelligent Investor

How to Find the Best Style ETFs

Finding the best ETFs is an increasingly difficult task in a world with so many to choose from.

Finding the best ETFs is an increasingly difficult task in a world with so many to choose from.

You Cannot Trust ETF Labels

There are at least 42 different Large-cap Value ETFs and at least 223 ETFs across all styles. Do investors need that many choices? How different can the ETFs be?

Those 42 Large Cap Value ETFs are very different. With anywhere from 22 to 1,408 holdings, many of these large cap ETFs have drastically different portfolios, creating drastically different investment implications.

I am sure that Large Cap Value ETFs hold many of the same big stocks such as Exxon Mobil (XOM), Coca Cola (KO), and Wells Fargo (WFC). However, investors need to know what else those ETFs hold before they can say they have done their due diligence.

The same is true for the ETFs in any other style, as each offers a very different mix of good and bad stocks. Some styles have lots of good stocks and offer quality funds. The opposite is true for some styles, while others lie in between these extremes with a fair mix of good and bad stocks. For example, Large Cap Value, per my 3Q Style Rankings report, ranks second out of 12 styles when it comes to providing investors with quality ETFs. Large-cap Blend ranks first. Small-cap Value ranks last. Details on the Best & Worst ETFs in each style are here.

Still, the bottom line is: ETF labels do not tell you what kind of stocks you are getting in any given ETF.

Paralysis By Analysis

I firmly believe ETFs for a given style should not be all that different. I think the large number of Large Cap Value (or any other) style of ETFs hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many ETFs. Analyzing ETFs, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each ETF. As stated above, that can be as many as 1,408 stocks for one ETF.

Any investor worth his salt knows that knowing the holdings of an ETF is critical to finding the best ETF.

Figure 1: Best Style ETFs

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Sources: New Constructs, LLC and company filings

The Danger Within

Why do investors need to know the holdings of ETFs before they buy? They need to know to be sure they do not buy an ETF that is likely to perform poorly. 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. No matter how cheap, if it holds bad stocks, the ETF’s performance will be bad.

PERFORMANCE OF ETF’s HOLDINGs = PERFORMANCE OF ETF

Finding the Style ETFs with the Best Holdings

Figure 1 shows my top rated ETF for each style. Importantly, my ratings on ETFs are based primarily on my stock ratings of their holdings. My firm covers over 3,000 stocks and is known for the due diligence we do for each stock we cover. Accordingly, our coverage of ETFs leverages the diligence we do on each stock by rating ETFs based on the aggregated ratings of the stocks each ETF holds.

iShares MSCI USA Quality Factor ETF (QUAL) is the top-rated All Cap Blend ETF and the top-rated ETF overall of the 223 style ETFs I cover. Only the Large Cap Blend, Large Cap Value and All Cap Blend styles contain any Attractive (i.e. 4-star) rated ETFs while the best every other style can offer is a Neutral or 3-star ETF, or even a Dangerous or 2-star ETF.

Sometimes, you get what you pay for.

It is troubling to see one of the best style ETFs, First Trust Capital Strength ETF (FTCS), have just $46 million in assets. The largest ETF in that Large Cap Value style, iShares Russell 1000 Value ETF (IWD), has over $19 billion in assets though it only gets a Neutral (3-star) rating. IWD’s expense ratio of 0.24% is lower than FTCS’s expense ratio of 0.72%, but as I state above, no matter how cheap an ETF, if it does not hold good stocks it will not perform well. Sometimes, you get what you pay for.

Another example of how you sometimes get what you pay for: Vanguard Small Cap Value ETF (VBR). VBR has over $3 billion in assets despite getting a Dangerous (2-star) rating. Investors seem to be attracted to its low expense ratio of 0.23% with less regard for the quality of its holdings. Meanwhile, the top-rated Small Cap Value ETF, iShares Enhanced U.S. Small Cap ETF (IESM), has a 3-star rating but only $3 million in assets.

I cannot help but wonder if investors would leave VBR if they knew that it has such a poor portfolio of stocks. It is cheaper than IESM, but as previously stated, low fees cannot growth wealth; only good stocks can.

Sometimes, you DON’T get what you pay for.

One of the smaller ETFs in Figure 1 is First Trust Capital Strength ETF (FTCS) with just $46 million in assets. Sadly, other ETFs with more assets and similar portfolios (virtually identical top 5 holdings) charge more than FTCS. In other words, Large Cap Value ETF investors are paying extra fees for no reason.

Specifically, at 0.78%, First Trust Value Line Dividend Fun (FVD) with $712 million in assets and my Dangerous rating charges more than FTCS, which charges 0.72% and gets my Attractive rating. Sometimes, you do not get what you pay for.

The worst ETF in Figure 1 is Small Cap Blend’s PowerShares RAFI Fundamental Pure Small Core Portfolio (PXSC), which gets a Dangerous (2-star) rating. One would think ETF providers could do better for this style.

I recommend investors only buy ETFs with more than $100 million in assets. You can find more liquid alternatives for the other funds on my free ETF screener.

Covering All The Bases, Including Costs

My ETF rating also takes into account the total annual costs, which represents the all-in cost of being in the ETF. This analysis is simpler for ETFs than funds because they do not charge front- or back-end loads and transaction costs are incurred directly. There is only the expense ratio, which is normally quite low. However, my ratings penalize those ETFs with abnormally high expense ratios or any other hidden costs.

Top Stocks Make Up Top ETFs

One of my favorite holdings in Guggenheim Russell Top 50 ETF (XLG) is International Business Machines (IBM), which gets my Very Attractive (5-star) rating. IBM has an impressive track record of profit growth over long periods of time. Since 2002, it has grown after-tax profit (NOPAT) by over 12%% compounded annually and has a top quintile return on invested capital (ROIC) of 16%. Despite this track record of growth, its valuation of ~$197/share gives it a price to economic book value ratio of slightly less than 1.0. This valuation implies that the market expects the company’s NOPAT to never grow past their current levels. A track record of profitability combined with such a low valuation means an attractive risk/reward for investors. A 2.8% allocation to IBM helps to explain why XLG gets my Attractive rating.

iShares High Dividend ETF (HDV) is the ETF with the most assets ($3.2 billion) to get my Attractive (4-star) rating. McDonald’s (MCD) is one of my favorite stocks held by HDV and earns my Attractive rating. MCD has grown NOPAT by 12% compounded annually since 2002. Moreover, MCD has a top-quintile return on invested capital (ROIC) of 16%. As per my June article on MCD, over the last decade, MCD increased its number of stores and profits at the same time, driving up its economic earnings by 35% compounded annually. 

With such an impressive track record of growth, it is surprising that MCD is trading at only ~$97/share. This stock price gives MCD a price to economic book value ratio of 0.9, which means that the market is predicting a permanent 10% decline in MCD’s profitability. This kind of decline seems unlikely given MCD’s profit history, management expertise, and planned expansion into foreign markets. The stock is currently trading at a discount for any hungry investor. 

André Rouillard contributed to this post

Disclosure: David Trainer and André Rouillard receive no compensation to write about any specific stock, sector, or theme.

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Trainer brings insight and transparency to research on stocks, ETFs and mutual funds.
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