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3 Recent Standout ETFs to Avoid

These enticing ETFs are primed to disappoint.

Bryan Armour: The start to 2023 has seen the winners of the last bull market reemerge after a major downturn in 2022. Chasing recent performance can be tempting as fortunes turn for these strategies, but it wasn’t long ago that investors late to the party were left holding the bag when the bubble burst.

Today, I’m highlighting three ETFs whose performance year to date is commendable but should be viewed with skepticism by investors. These strategies lack long-term merit and carry high fees relative to their top competitors. Managing risk is the name of the game right now, and these ETFs are known for leaning into risk. There are better options that come with more thoughtfully constructed portfolios and lower fees. Long-term investors should pass on these ETFs.

3 Recent Standout ETFs to Avoid

  1. Invesco QQQ Trust QQQ
  2. ARK Innovation ETF ARKK
  3. First Trust Tactical High Yield ETF HYLS

The first ETF on my list is Neutral-rated Invesco QQQ Trust, or QQQ. This ETF was among the most popular in recent years, but its fate turned in 2022 as it lost 32.50%. It’s popular for a good reason; its among the top performers in the large-growth Morningstar Category over the past 10 years.

But QQQ misses the mark on the economic rationale behind its portfolio construction. It tracks the Nasdaq-100 Index, which was borne out of Nasdaq’s desire to promote their exchange. It picks the 100 largest nonfinancial firms listed on Nasdaq and weights them by market cap, arbitrarily excluding stocks listed on other exchanges.

Tech stocks make up half of QQQ’s portfolio, and it’s top-heavy with 54% of its assets in its top 10 holdings. It could be a recipe for disaster to stack companies with shared risk characteristics just because they are listed on the same exchange.

The second ETF on my list is Negative-rated ARK Innovation ETF, ticker ARKK. Cathie Wood did a great job selling her investing vision, eventually running into capacity problems as her flagship fund gained so many assets. But just as the coffers swelled to the limit, the bubble popped, leading ARKK to drop over three quarters from its highs. ARKK severally punished investors for chasing returns over the past two years. But its high-water mark and Cathie Wood’s excessive optimism have kept investors’ attention.

ARK favors companies that are often unprofitable and whose stock prices are highly correlated to one another. The result is a concentrated portfolio of companies that burn through cash and come with extreme valuations and poor profitability.

The portfolio currently holds 27 stocks with 64% of its assets in its top 10 holdings. It has become increasingly concentrated as Cathie Wood attempts to right the ship—a fact that belies ARK’s poor risk management. Cathie Wood has gone so far as to suggest that risk management lies not with her but with those who invest in ARK’s funds. Buyer beware.

The last ETF on my list is Neutral-rated First Trust Tactical High Yield ETF, ticker HYLS. This ETF is different from the other two in that it hasn’t had periods of staggering outperformance. That’s likely an artifact of its 1.27% fee that creates a high hurdle for its managers to overcome. Unsurprisingly, the fund takes on a lot of risk in its attempt to earn back its high fee.

This strategy uses borrowing to leverage its portfolio to roughly 105% to 125% of net assets. It also shorts U.S. Treasuries, typically amounting to between 5% and 25% of assets. This can insulate the fund from interest shocks, but it also introduces risk. This fund adds even more risk by targeting the lower-quality segments of the already risky high-yield bond market.

This ETF is poised for big losses should market conditions continue to deteriorate, potentially causing interest rates to drop, credit spreads to widen, and default rates to increase. Investors would be wise to look elsewhere for yield.

Watch “3 Great Growth ETFs for 2023″ for more from Bryan Armour.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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