The dominance of health care exchange-traded funds (ETFs) in terms of five-year returns is weakening compared to last year, but they still account for the majority of the 10 best-performing ETFs.

Also creeping into the top spots were consumer discretionary, consumer cyclical and long-term Treasury ETFs.

Over the last five years, health care ETFs have gained an annualized 15.3% on average. While individual health care ETFs dominate the top 10 list, the health care sector as a whole is now underperforming the homebuilders sector, which gained an annualized 15.6% on average over the last five years.

Following the homebuilders sector is the consumer staples sector and long-term government bond categories, which have gained an average of 13.9% and 13.7%, respectively. The health care sector tends to perform well through the different stages of an economic cycle because of the population’s perpetual need for health care and its services. Also aiding health care’s outperformance has been innovation in biotechnology, greater access to health insurance and aging of the baby boomers.

The homebuilders sector is sensitive to the economic cycle and tends to perform well when the economy is strengthening and trends in interest rates are favorable.

The consumer staples sector has often been regarded as “recession-proof” because consumers are going to buy the necessities no matter the economic conditions. The paradox in the current top categories list is that consumer staples and consumer discretionary (homebuilders in this case) have very different levels of sensitivity to economic cycles. A closer look, however, shows that the two sectors’ impressive five-year performance figures come from different time periods within the last five years.

The homebuilders sector’s five-year outperformance is largely attributable to its outperformance in 2012, following the recovery of the real estate sector after 2009. Low interest rates have supported decent relative performance since 2012: The sector gained 21.6% in 2013, 3.9% in 2014 and 2.7% in 2015.

On the other hand, the consumer staples sector has been more consistent on a comparative basis, gaining 9.7% in 2011, 11.1% in 2012, 30.6% in 2013, 13.4% in 2014, 7.4% in 2015 and 9.7% year-to-date through June 2016. Consumer staples stocks tend to have higher dividend yields, and increased demand for yield has helped their performance. As investors continue to rotate into safe-haven assets, the increased demand for yield is leading prices higher (and, subsequently, pushing yields lower). This trend toward yield is demonstrated by the long-term government bond category, which has gained 27.2% on average over the trailing 12 months and is the fourth-best-performing sector over the last five years.

There are 36 ETFs within the health care category, compared to three in the homebuilders category and 14 in the consumer staples category. The number of ETFs within a category will affect the category averages.

Changes to the ETFs Included

This year, new requirements have been implemented for ETFs to be included in the top list. First, ETFs with expense ratios more than 10% above the average of their respective category average are eliminated. Secondly, ETFs with a category risk index more than 50% above the average for their respective category are disqualified. Some investors may retort, “Who cares if the risk and expense are higher…I’m getting more return!” While they are likely familiar with the phrase “past performance is not indicative of future performance,” it’s a concept worth revisiting.

Exchange-traded funds are, for the most part, designed to passively track an index. While active ETFs are entering the market, only 9% (156) of ETFs are actively managed as of June 30, 2016. Higher expense ratios require higher returns just to break even with lower-cost funds. Additionally, past research has shown that funds with higher expense ratios underperform over time. We aren’t advocating that you purchase ETFs based solely on expense ratios, but if there is a less expensive alternative in the same category it may be worth investigating.

Higher risk doesn’t lead to higher returns, either, which brings us to the relative risk limitation. While higher risk can lead to higher return, as is the case with some of the ETFs that were excluded from this year’s top list, better performance is not guaranteed in the future. Risk applies to the downside and upside; while it may boost returns during rising markets, it can also lessen returns during declining markets. We don’t know which asset classes, investment styles, sectors or industries will be in favor in the future. We do know that higher-risk funds are more likely to sustain comparatively bigger swings in monthly and annual returns, calling into question their ability to continue to outperform.

An example of a higher-risk ETF excluded this year is the SPDR S&P Biotech (XBI). Over the last five years, this ETF has returned an annualized 17.9%, but its total risk index is 3.19, almost double its category average of 1.63. If SPDR S&P Biotech had been included, it would have been among the top-performing ETFs over the last five years, but it’s worth noting that the ETF has declined 22.7% this year (as of June 30), compared to the health care category average decline of 9.8%. SPDR S&P Biotech’s standard deviation (variance of returns) of 34.9% is much higher than the health care category average of 17.8%, which speaks to the ETF’s volatility.

Table 1. Top ETFs Over Five Years

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Brief List of Top 50 ETFs Over Five Years

	Category	NAV Ret 5 Year Ann’l (%)	Yield (%)	Expense Ratio (%)
ETF Name (Ticker)
Overall Five-Year Top Performers
iShares Nasdaq Biotechnology (IBB)	Health Sector	19.5	0.1	0.48
Guggenheim S&P 500 Eq Wt Cons Stapl ETF (RHS)	Consumer Staples Sector	17.7	1.6	0.40
PIMCO 25+ Year Zero Coupon US Trs ETF (ZROZ)	Gov’t Bond: Long-Term	17.5	1.7	0.16
iShares US Home Construction (ITB)	Homebuilders Sector	17.4	0.4	0.43
Health Care Select Sector SPDR ETF (XLV)	Health Sector	17.1	1.5	0.14
Vanguard Health Care ETF (VHT)	Health Sector	17.0	1.9	0.09
iShares US Healthcare (IYH)	Health Sector	16.8	2.1	0.43
Vanguard Extended Duration Treasury ETF (EDV)	Gov’t Bond: Long-Term	16.7	2.5	0.10
Guggenheim S&P 500 Eq Weight HC ETF (RYH)	Health Sector	16.5	0.5	0.40
iShares US Pharmaceuticals (IHE)	Health Sector	16.3	1.0	0.43
iShares US Medical Devices (IHI)	Health Sector	15.9	1.1	0.43
Consumer Discret Sel Sect SPDR ETF (XLY)	Consumer Discret Sector	15.9	1.6	0.14
iShares US Consumer Services (IYC)	Consumer Discret Sector	15.8	1.0	0.43
iShares US Aerospace & Defense (ITA)	Industrials Sector	15.3	0.9	0.43
Consumer Staples Select Sector SPDR ETF (XLP)	Consumer Staples Sector	15.1	2.3	0.14
Vanguard Consumer Staples ETF (VDC)	Consumer Staples Sector	15.0	3.3	0.10
PowerShares QQQ ETF (QQQ)	Large-Cap Stock	14.9	1.1	0.20
Vanguard Consumer Discretionary ETF (VCR)	Consumer Discret Sector	14.9	2.0	0.10
iShares US Healthcare Providers (IHF)	Health Sector	14.8	0.2	0.43
First Trust Dow Jones Internet ETF (FDN)	Technology Sector	14.8	0.0	0.54
PowerShares S&P 500 Low Volatility ETF (SPLV)	Large-Cap Stock	14.4	2.0	0.25
SPDR S&P Pharmaceuticals ETF (XPH)	Health Sector	14.3	0.5	0.35
iShares Global Healthcare (IXJ)	Health Sector	14.0	2.3	0.47
SPDR S&P Homebuilders ETF (XHB)	Homebuilders Sector	14.0	0.6	0.35
SPDR S&P Dividend ETF (SDY)	Large-Cap Stock	13.9	2.3	0.35
WisdomTree High Dividend ETF (DHS)	Large-Cap Stock	13.9	3.1	0.38
iShares Select Dividend (DVY)	Mid-Cap Stock	13.8	3.1	0.39
Vanguard Utilities ETF (VPU)	Utilities Sector	13.7	2.9	0.10
WisdomTree MidCap Dividend ETF (DON)	Mid-Cap Stock	13.6	2.3	0.38
PowerShares S&P 500 Quality ETF (SPHQ)	Large-Cap Stock	13.6	1.8	0.29
Utilities Select Sector SPDR ETF (XLU)	Utilities Sector	13.6	3.1	0.14
iShares US Utilities (IDU)	Utilities Sector	13.5	3.4	0.43
SPDR S&P Insurance ETF (KIE)	Financial Sector	13.3	1.7	0.35
iShares Core High Dividend (HDV)	Large-Cap Stock	13.2	3.4	0.12
iShares US Consumer Goods (IYK)	Consumer Staples Sector	13.2	2.2	0.43
iShares Russell Top 200 Growth (IWY)	Large-Cap Stock	13.2	1.6	0.20
Vanguard High Dividend Yield ETF (VYM)	Large-Cap Stock	13.1	3.1	0.09
iShares Morningstar Large-Cap (JKD)	Large-Cap Stock	13.1	2.4	0.20
iShares North American Tech (IGM)	Technology Sector	13.1	1.0	0.47
Technology Select Sector SPDR ETF (XLK)	Technology Sector	13.1	1.9	0.14
Fidelity Nasdaq Composite Tr Stk ETF (ONEQ)	Large-Cap Stock	13.0	1.2	0.21
Vanguard S&P 500 Growth ETF (VOOG)	Large-Cap Stock	12.8	1.5	0.15
iShares S&P 500 Growth (IVW)	Large-Cap Stock	12.7	1.6	0.18
SPDR S&P 500 Growth ETF (SPYG)	Large-Cap Stock	12.7	1.6	0.15
Vanguard Mega Cap Growth ETF (MGK)	Large-Cap Stock	12.7	1.5	0.09
iShares Morningstar Large-Cap Growth (JKE)	Large-Cap Stock	12.6	1.0	0.25
iShares PHLX Semiconductor (SOXX)	Technology Sector	12.5	1.3	0.47
Vanguard Information Technology ETF (VGT)	Technology Sector	12.5	2.0	0.10
Vanguard REIT ETF (VNQ)	Real Estate Sector	12.4	3.4	0.12
Guggenheim S&P 500 Pure Value ETF (RPV)	Large-Cap Stock	12.3	2.2	0.35
Copyright 2016 American Association of Individual Investors and Morningstar, Inc. All Rights Reserved.

Source: “The Individual Investor’s Guide to Exchange-Traded Funds 2016,” August 2016 AAII Journal.
Data from Morningstar Inc. is through June 30, 2016.
*Bull market is defined as 3/1/2009 through 6/30/2016. Bear market is defined as 11/1/2007 through 2/28/2009.

Health Care Phasing Out of Top

Last year, the top 10 ETFs over the last five years were all health care funds. This time around, as of June 30, six of the top 10 ETFs over the last five years track a health-care-related index (see the top of Table 1). Even without the added restrictions imposed on the top performers, there would still be six out of 10 health care ETFs in the top list.

Three of the funds in this year’s top-10 list are holdovers from last year’s top five-year performance rankings. The iShares Nasdaq Biotechnology (IBB) moved from second to first place, iShares U.S. Pharmaceuticals (IHE) moved from sixth to 10th place and Guggenheim S&P 500 Equal Weight Health Care (RYH) moved from 10th to ninth place. Had we allowed higher expense ratios and higher risk ETFs to be among the top performers, PowerShares Dynamic Pharmaceuticals (PJP) and SPDR S&P Biotech (XBI) would have bumped the iShares US Pharmaceuticals and the Guggenheim S&P 500 Equal Weight Health Care off the list.

The newly added top performers that were not in the health care arena include the Guggenheim S&P 500 Equal Weight Consumer Staples (RHS), which has gained an annualized 17.7% over the last five years, PIMCO 25+ Year Zero Coupon U.S. Treasury (ZROZ) in third place with a five-year annualized gain of 17.5% and iShares U.S. Home Construction (ITB) and Vanguard Extended Duration Treasury (EDV), which returned an annualized 17.4% and 16.7%, respectively, over the last five years.

PIMCO 25+ Year Zero Coupon U.S. Treasury and Vanguard Extended Duration Treasury are both in the long-term government debt category and invest in U.S. Treasury STRIPS, zero-coupon bonds with a weighted maturity of over 20 years. Zero coupons are bonds without the cash flow of coupons; no interest is paid and bondholders only receive the par value of the bond (typically $100,000) at maturity. STRIPS are usually sold at a significant discount to face value and are particularly sensitive to interest rate movements. These investments are often attractive to investors who believe interest rates will hold steady or decline. The longer a security’s duration, the more sensitive it will be to interest rate changes (PIMCO 25+ Year Zero Coupon U.S. Treasury has an average effective duration of 27.4 years, while Vanguard Extended Duration Treasury has an average effective duration of 24.8 years). PIMCO 25+ Year Zero Coupon U.S. Treasury and Vanguard Extended Duration Treasury have tax-cost ratios of 1.3% and 1.5%, respectively. The tax-cost ratio measures how much a fund’s annualized return is reduced by taxes on distributions. Even though these two ETFs do not invest in coupon-paying bonds, they distribute cash to shareholders with proceeds from the sale and/or maturity of the bonds.

Interestingly, two ETFs that operate in opposite categories made it to the top-performing list: iShares U.S. Home Construction (ITB), which is more economically sensitive, and Guggenheim S&P 500 Equal Weight Consumer Staples (RHS), which is less economically sensitive. IShares U.S. Home Construction invests in the homebuilding segment broadly by including stocks from related industries like home furnishings, building products and home-improvement retailers. Keep the targeted focus of this ETF in mind: The fund is directly dependent on the strength of and sentiment toward the housing industry. The ETF’s enticing five-year performance is boosted by its 78.9% return during 2012. It has stayed afloat since then, gaining 17.8% in 2013, 4.7% in 2014, and 5.0% in 2015; it’s up 2.2% year-to-date through June. IShares U.S. Home Construction is one of two ETFs with significant exposure to the homebuilding sector included in Table 1; the other is SPDR S&P Homebuilders (XHB) which has a lower expense ratio than iShares U.S. Home Construction, but has lagged on an annualized five-year basis, gaining 14.0% (compared to ITB’s 17.4%).

Guggenheim S&P 500 Equal Weight Consumer Staples’ (RHS) annualized five-year performance is above that of iShares U.S. Home Construction (17.7% versus 17.4%) and it has had comparatively higher returns year-to-year since 2012, gaining 32.6% in 2013, 17.9% in 2014, and 13.1% in 2015; it is up 12.2% year-to-date through June. The iShares U.S. Home Construction ETF is able to compete with the Guggenheim S&P 500 Equal Weight Consumer Staples ETF on a five-year annualized basis because of its 78.9% gain in 2012, compared to the Guggenheim S&P 500 Equal Weight Consumer Staples ETF’s gain of 12.2% in 2012.

Which Funds Were Included

The list of top ETFs was largely restricted to those with five years of annual return data and a minimum of $400 million in assets. (Exceptions were made when the performance of a smaller fund warranted it.) ETFs intended to provide double or triple the return of their underlying index or that follow inverse strategies (they rise in price when the underlying index falls) were excluded from consideration. These types of funds are designed to be held for short periods of time, not several years. Additionally, funds were excluded from consideration if their expense ratio was more than 10% above that of its category average, or their risk index was more than 50% higher than that of its category.

Table 1 also shows the top ETFs by category. Five-year performance was calculated through June 30, 2016, to match the statistics displayed in “The Individual Investor’s Guide to Exchange-Traded Funds 2016,” which was published in the August 2016 AAII Journal.

In addition to five-year performance, returns for the year to date, the last 12 months and each of the past five years, and annualized three-year returns are displayed, along with returns for the most recent bull market (March 1, 2009, through June 30, 2016) and bear market (November 1, 2007, through February 28, 2009), where available. Returns that are in the top 25% of all exchange-traded funds within their investment category are shown in boldface. Other pertinent information presented includes yield, tax-cost ratio, risk, portfolio composition and expenses. Risk numbers that are in the lowest 25% of all ETFs within the investment category are shown in boldface. Five-year annual total returns based on market value are also displayed to show how closely each fund’s price performance matches its net asset value performance. The bigger the difference, the larger the premium or discount that fund shares have traded at over the period.

Why is a five-year time period desired? A five-year return is long enough that it balances consistency of performance with changing market and economic conditions. Five-year performance is used for our mutual fund comparison article (“Top Mutual Funds Over Five Years: Health Care Remains on Top,” March 2016 AAII Journal). Although most ETFs track indexes and are not influenced by active management as the majority of mutual funds are, looking at the longer five-year performance of ETFs is beneficial because it gives the same balanced perspective that a shorter period cannot.

Look Beyond Performance

There is always a temptation to look more favorably at the best-performing funds. Though performance does matter, it is just one factor to consider.

You should also consider your portfolio needs. A basic allocation of ETFs holding domestic stocks with varying market capitalizations, international stocks, government bonds, corporate bonds and international bonds will serve most investors well. Once this basic portfolio allocation is established, other asset classes—such as real estate and commodities—and more specialized funds can be added.

Sector and country funds can boost a portfolio’s returns, but prudence is required when using them. Make sure you understand the factors that have driven a sector’s performance over the past few years and how likely it is that those trends will continue in the future. You cannot safely navigate a winding road by only using a rear-view mirror. Country-specific ETFs can allow you to target specific markets but can be more volatile and expose you to exchange-rate risks.

Be sure you fully understand the index that the ETF is designed to follow. Similar-sounding indexes can have different return characteristics. They can also either hold different stocks or weight the same stocks differently. A quick visit to an ETF family’s website can give you the list of current holdings and information about the underlying index it tracks. Many index providers also give more detailed information about their indexes on their own websites. (Type the index’s name into an Internet search engine, such as Google, to find the specific website.)

Finally, use this rule of thumb when looking at ETFs: “Just because you can invest in something, doesn’t mean you should.” Buy only those ETFs that you fully understand; avoid those tracking indexes or investing in sectors or countries with risks that you cannot identify.

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