How To Find The Best Sector ETFs

By David Trainer and Kyle Guske II of New Contstructs
Date: Wednesday, April 30, 2014 12:53 PM EST

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 45 different Financial ETFs and at least 181 ETFs across all sectors. Do investors need that many choices? How different can the ETFs be?

Those 45 Financial ETFs are very different. With anywhere from 19 to 549 holdings, many of these Financial ETFs have drastically different portfolios, creating drastically different investment implications.

The same is true for the ETFs in any other sector, as each offers a very different mix of good and bad stocks. Some sectors have lots of good stocks and offer quality funds. The opposite is true for some sectors, while others lie in between these extremes with a fair mix of good and bad stocks. For example, the Financial sector, per my 2Q Sector Rankings Report ranks ninth out of 10 sectors when it comes to providing investors with quality ETFs. Consumer Staples ranks first. Utilities ranks last. Details on the Best & Worst ETFs in each sector are here

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

Paralysis By Analysis

I firmly believe ETFs for a given sector should not all be that different. I think the large number of Financial (or any other) sector 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 549 stocks, and sometimes even more, for one ETF.

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

Figure 1: Best Sector ETFs

Screen shot 2014-04-30 at 8.26.58 AMSources:   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 a fund that might blow up. Buying a fund 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 FUND’S HOLDINGS = PERFORMANCE OF FUND

Finding the Sector ETFs with the Best Holdings

Figure 1 shows my top rated ETF for each sector. Importantly, my 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 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.

Fidelity MSCI Consumer Staples Index ETF (FSTA) is the top-rated Consumer Staples ETF and the overall second-rated fund of the 181 sector ETFs that I cover. Only the Consumer Staples and Financial sectors contain any Attractive (i.e. 4-star) or better rated ETF’s. The best every other sector can offer is a Neutral or 3-star ETF.

Sometimes, you get what you pay for.

It is troubling to see one of the best sector ETFs, PowerShares KBW Property & Casualty Insurance Portfolio (KBWP) have just $10 million in assets despite its Very Attractive of 5-star rating. On the other hand, Dangerous-rated Vanguard Financials ETF (VFH) has $2,002 million in assets. VFH has lower total annual costs than KBWP (0.21% and 0.39% respectively), but low costs cannot drive positive performance. Quality holdings are the ultimate driver of performance.

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

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

Fidelity MSCI Telecommunications Services Index ETF (FCOM) is one of the smallest ETFs in Figure 1 with just $20 million in assets. Sadly, other Telecom ETFs with more assets and inferior portfolios charge more than FCOM. In other words, Telecom ETF investors are paying extra fees for no reason.

iShares U.S. Telecommunications ETF (IYZ) is one of the worst ETFs in the Telecom sector. It gets my Very Dangerous rating based off the fact that less than 12% of its assets are allocated to Attractive-or-better rated stocks, while 76% is allocated to Dangerous-or-worse stocks. IYZ also has total annual costs of 0.53%, higher than FCOM’s 0.13%. One would think that IYZ would have fewer assets than FCOM, but instead it has over $590 million. Investors are paying extra fees for poor holdings.

The worst ETF in Figure 1 is PowerShares DWA Utilities Momentum (PUI), which gets a Very Dangerous (1-star) rating. One would think ETF providers could do better for this sector.

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 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 complex for mutual funds, but straightforward for ETFs, where all costs are factored into the expense ratio. While costs play a smaller role than holdings, my ratings penalize those ETFs with abnormally high costs.

Top Stocks Make Up Top ETFs

Medtronic Inc. (MDT) is one of favorite holdings in IHI and earns my Attractive rating. Over the past decade, MDT has grown after-tax profit (NOPAT) by 9% compounded annually, and currently earns a return on invested capital (ROIC) of 13%. Despite the consistent growth of MDT, the stock is not priced accordingly. At its current price of ~$58/share, MDT has a price to economic book value (PEBV) ratio of 1.1. This ratio implies the market expects MDT to grow NOPAT by only 10% for the remaining life of the company. MDT should have no trouble surpassing those low expectations. Allocation to high quality stocks such as MDT make IHI the top rated ETF in the Health Care sector.

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