How To Avoid The Worst Style ETFs In Q1 Of 2025

Why Are There So Many ETFs?

The exchange-traded fund (ETF) market has exploded in recent years, with hundreds of new ETFs being launched annually. The simple reason behind this proliferation is that creating and selling ETFs is a profitable business for Wall Street. Financial institutions continuously develop new ETFs to meet the demands of investors seeking exposure to various asset classes, sectors, and investment strategies. While this growth offers investors a wide range of choices, it also introduces challenges. With so many ETFs available, it can be difficult for investors to distinguish between high-quality products and those that may underperform or come with hidden risks.

To help investors navigate this complex landscape, it’s essential to identify red flags that can help avoid the worst ETFs. By focusing on three key issues—liquidity, fees, and the quality of holdings—investors can make more informed decisions and steer clear of ETFs that are unlikely to deliver strong returns.

The Dangers of Low Liquidity

One of the easiest red flags to spot is inadequate liquidity.ETFs with low assets under management (AUM) or low trading volumes can pose significant risks to investors. A general rule of thumb is to avoid ETFs with less than $100 million in assets. Low AUM often leads to poor liquidity, which can result in a mismatch between the ETF’s market price and the underlying value of its holdings. This discrepancy can make it difficult to buy or sell shares at a fair price, especially during periods of market stress.

Additionally, small ETFs typically have lower trading volumes, which can lead to wider bid-ask spreads. These larger spreads increase trading costs, effectively reducing investors’ returns. While small ETFs may offer unique exposure to niche markets or strategies, the risks associated with low liquidity often outweigh the potential benefits. By sticking to ETFs with higher AUM and greater trading activity, investors can minimize these risks and ensure smoother execution of their trades.

The Hidden Costs of High Fees

Another critical factor to consider when evaluating ETFs is the total annual cost. While ETFs are generally known for being cost-effective, not all products are created equal. Some ETFs come with high expense ratios that can erode returns over time. To avoid overpaying, investors should focus on ETFs with total annual costs below the average for their category. For example, in the case of U.S. equity style ETFs, the average total annual cost is 0.49%, while the weighted average is even lower at 0.13%. This discrepancy highlights that investors tend to favor low-cost ETFs, and for good reason.

Figures like the InfraCap Equity Income Fund (ICAP) and ETFs from WBI Investments often rank among the most expensive, while State Street’s SPDR Portfolio S&P 500 ETF (SPLG) stands out as one of the cheapest options. However, it’s important to remember that low fees don’t always guarantee quality holdings. For instance, the State Street SPDR Portfolio S&P 600 Small Cap ETF (SPSM) has an extremely low expense ratio of 0.03%, but its holdings are subpar, earning it an unattractive rating. This underscores the importance of looking beyond fees to evaluate the overall quality of an ETF.

The Importance of Quality Holdings

While avoiding high fees and low liquidity is crucial, the most challenging—and often the most critical—factor to evaluate is the quality of an ETF’s holdings. An ETF’s performance is ultimately determined by the stocks or securities it holds. Even if an ETF is cheap, poor holdings can lead to underwhelming returns. For example, the VictoryShares Free Cash Flow ETF (VFLO) is one of the highest-rated style ETFs, thanks to its solid holdings, despite having a management fee of 0.21%. On the other hand, ETFs like the Renaissance IPO ETF (IPO) and the Alger Weatherbie Enduring Growth ETF (AWEG) struggle with both high fees and poor-quality holdings, making them unattractive options for investors.

Several ETF providers, including State Street and Vanguard, frequently appear on lists of ETFs with the worst holdings. This doesn’t mean their products are inherently bad, but it does highlight the need for due diligence. One of the worst offenders is the Invesco NASDAQ Future Gen 200 ETF (QQQS), which holds poor stocks and charges high fees, earning it a very unattractive rating. Investors must remember that an ETF’s performance is only as strong as its underlying holdings. Just as you wouldn’t buy a stock without analyzing its business model and financials, you shouldn’t invest in an ETF without researching its portfolio.

The Danger Within: Why ETF Holdings Matter

The relationship between an ETF’s holdings and its performance can’t be overstated. At its core, an ETF is a basket of securities, and its returns are directly tied to the performance of those securities. If an ETF holds poorly performing or overvalued stocks, it will likely underperform, regardless of its fees. Conversely, an ETF with high-quality, undervalued holdings can generate strong returns even with slightly higher fees. This is why it’s so important to look beyond the surface level and analyze the underlying portfolio.

Buying an ETF without examining its holdings is akin to buying a stock without understanding its business model or financial health. It’s a gamble that often ends poorly. By conducting proper due diligence and focusing on ETFs with strong, well-managed portfolios, investors can significantly improve their chances of achieving their financial goals.

Conclusion: Smart Investing in the ETF Era

The ETF market offers unparalleled diversity and accessibility, but it also presents challenges for investors. With so many products to choose from, it’s easy to get caught up in the hype and overlook critical red flags. By focusing on liquidity, fees, and holdings, investors can avoid the pitfalls of bad ETFs and make more informed decisions.

Remember, the cheapest ETF isn’t always the best, and the most popular ETF isn’t necessarily the highest quality. The key to success lies in balancing cost, liquidity, and portfolio quality. By doing your homework and staying disciplined, you can navigate the complex world of ETFs and build a portfolio that aligns with your financial goals.