This year, we were able to extend our analysis of the top exchange-traded funds (ETFs) to five years, as opposed to three years.

We have wanted to look at five-year performance, but up until now there were too few ETFs with long enough track records to conduct the analysis. Out of the 1,752 ETFs and exchange-traded notes (ETNs) currently listed on U.S. exchanges, only 172 have been in existence for at least 10 years, while 851 are at least five years old and 1,228 have three full years of return data. If we had previously used a five-year period, it would have resulted in several ETF categories showing too few funds.

Certain bond categories were problematic in years past and kept us from expanding the analysis to five years. For example, in the international general bond category, SPDR Barclays International Corporate Bond ETF (IBND) was just barely able to provide a five-year return record as of June 30, 2015.

Also, if we had used a five-year period last year, several ETFs that made the three-year top-performing list for their category would have been left out. For example, the Vanguard Intermediate-Term Corporate Bond Index ETF (VCIT) and the Vanguard Long-Term Corporate Bond Index ETF (VCLT) would have been excluded due to their launch date of November 19, 2009. Both of the top three-year performers in the short-term general bond category last year, the Vanguard Short-Term Corporate Bond Index ETF (VCSH) and the SPDR Barclays Capital Short Term Corp Bond (SCPB), would have also been excluded had we used a five-year period.

The lack of five-year performance is due to the fact that the ETF industry is still relatively young. The first ETF was created in 1993. Since then the industry has rapidly expanded, picking up the most steam within the last 10 years—especially so within the last five years. In 2006, 130 U.S. exchange-listed ETFs launched, marking the first time the number of new ETFs exceeded 100. Since 2006, every year has seen more than 100 launches; there have been 133 launches this year as of June 30, 2015. Thanks to the maturity level that the ETF industry has attained, we now have enough funds of significant size and return periods in all categories, including bonds, to expand the analysis to cover five years.

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 the “Top Mutual Funds Over Five Years: Health Care’s Vitals Look Good” (March 2015 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 three-year period cannot.

Health Care Dominates the Performance Rankings

The top 10 ETFs over the last five years as of June 30 are all health care funds. The sector dominates performance among ETFs to a much greater degree than in mutual funds: In this year’s analysis of the top mutual funds over five years as of December 30, 2014, health care funds accounted for four of the top 10 rankings. However, the six-month lag between December and June renders the “top performers” lists not entirely comparable. Although six months is seemingly short, it can make a difference in terms of which fund categories are represented. But with both the actively managed mutual fund and index-tracking ETF universes, the influence of sector strength is evident. Last year, six of the 10 top-performing ETFs over three years were also health care funds.

Six of the funds in this year’s top-10 list are holdovers from last year’s top three-year performance rankings.

The SPDR S&P Biotech ETF (XBI) jumped from fourth place to first, while iShares Nasdaq Biotechnology (IBB), PowerShares Dynamic Pharmaceuticals ETF (PJP) and the SPDR S&P Pharmaceuticals ETF (XPH) remained in the top five.

The top ETFs cover a range of industries in the health care sector, such as biotechnology, pharmaceuticals, life sciences and health care providers. This year’s top two funds (SPDR S&P Biotech ETF and iShares Nasdaq Biotechnology) both invest in biotechnology stocks, but share none of their 10 largest holdings. This is because they track different indexes and use different weighting methodologies, which can significantly impact holding composition, performance, volatility, turnover and expenses.

The SPDR S&P Biotech ETF follows an equal-weight strategy, which skews its portfolio more toward smaller-cap, early-stage biotech firms. Equal-weight ETFs tend to outperform market-capitalization-weighted ETFs when smaller stocks outperform the larger ones. This is because every stock in an equal-weight index has the same weight, irrespective of how large or small the companies they represent are. While the higher allocation to smaller companies can boost relative performance, it can also lead to higher price volatility, as is evident by SPDR S&P Biotech’s total risk index of 3.05. The equal-weighting of the index also leads to higher turnover. The ETF’s turnover of 86% is the second-highest of all the funds that made the top-10 list, second to only the 95% turnover for PowerShares Dynamic Biotech & Genome ETF (PBE), and much higher than the second-place top performer, iShares Nasdaq Biotechnology ETF, which had 33% turnover. With higher turnover, comes higher expense.

Speaking of expense, it’s important to remember that ETFs are tax-efficient, but not tax-free. The tax-cost ratio measures how much a fund’s annualized return is reduced by the taxes investors pay on distributions. In the case of the top two five-year performers, the SPDR S&P Biotech has a tax-cost ratio of 0.3%, while the iShares Nasdaq Biotechnology ETF’s tax-cost ratio is 0.0%. This means that on average each year, investors in the SPDR Biotech ETF lost 0.3% of their investment dollars to taxes for shares held in a taxable account.

The second-place iShares Nasdaq Biotechnology tracks biotechnology (80% of its holdings) and pharmaceuticals (15% of its holdings) stocks listed on the NASDAQ. The ETF tracks a modified market-cap-weighted index where larger-cap biotechnology firms maintain a higher presence than smaller-cap holdings. As a result, the fund has comparably less volatility, with a total risk index of 2.09.

The iShares Nasdaq Biotechnology ETF’s largest holdings—Celgene Corp. (CELG), Amgen Inc. (AMGN), Gilead Sciences (GILD), Regeneron Pharmaceuticals Inc. (REGN) and Biogen Inc. (BIIB)—are some of the biggest companies in the biotechnology sector. High rates of earnings growth over the past five years for most of these companies, along with their reduced sensitivity to economic trends, have helped attract investors to these stocks. The fund also benefits from the mergers and acquisitions trend in the pharmaceuticals industry.

Although market-cap-weighted indexes have their benefits, it’s important to remember their caveats. While assigning a bigger weighting to larger companies can lower overall volatility, it also ensures that the larger-cap holdings have a greater effect on performance. Weak price performance by one or more of the index’s top holdings would negatively impact overall returns. In the iShares Nasdaq Biotechnology ETF’s case, 58% of the portfolio is in its top-10 holdings. The iShares Nasdaq Biotechnology ETF does limit the weightings of its largest holdings, however.

The SPDR S&P Biotech ETF outperformed the iShares Nasdaq Biotechnology ETF in 2010, 2012 and 2014, and has outperformed it by 14.2% this year as of the end of June. Looking further back, iShares Nasdaq Biotechnology underperformed SPDR S&P Biotech during the bear market from November 1, 2007, to February 28, 2009, but subsequently outperformed during the bull market spanning from March 1, 2009, to June 30, 2015.

Top Performers Outside of Health Care

The four funds that dropped from last year’s top-10 ETF rankings are all are outside the health care sector: the iShares US Home Construction ETF (ITB), the First Trust US IPO Index ETF (FPX), the Guggenheim Spin-off ETF (CSD) and the SPDR S&P Homebuilders ETF (XHB). The shift to five-year performance helped to remove these funds out of this year’s top overall list. However, First Trust US IPO Index ETF, Guggenheim Spin-off ETF and the SPDR S&P Homebuilders ETF still rank among the top performers in their respective categories this year.

The First Trust US IPO Index ranks 11th in terms of five-year performance, closely followed by two more health care ETFs: the Vanguard Health Care ETF (VHT) and the iShares US Healthcare ETF (IYH). The First Trust US IPO Index made it to the top 10 list last year and the year prior. This ETF invests in companies that completed their initial public offerings within approximately the past four years. The First Trust US IPO ETF has ranked within the top quartile for large-cap stock ETFs during three out of the past five full-calendar years (not including its top performance year-to-date). While it is slightly more risky than its category average, as illustrated by its category risk index of 1.24, the ETF’s tax-cost ratio of 0.3% is below the large-cap category average of 0.6%.

Aside from the wave of outperformance by health care funds, two retail and consumer discretionary sector funds ranked among the top 20: SPDR S&P Retail ETF (XRT) in the 14th spot and the Vanguard Consumer Discretionary ETF (VCR) in the 16th spot.

What If We Ranked By Three-Year Performance?

For those curious about what the top-performing ETFs would have been if we continued to use a three-year period instead of expanding the analysis to five years, the results do not differ significantly. Seven of the 10 best-performing ETFs over the past five years also have among the best three-year returns. In order, they are: SPDR S&P Biotech ETF, iShares Nasdaq Biotechnology, First Trust NYSE Arca Biotech ETF (FBT), PowerShares Dynamic Biotech & Genome ETF, PowerShares Dynamic Pharmaceuticals ETF, SPDR S&P Pharmaceuticals ETF and First Trust Health Care AlphaDEX ETF (FXH). However, three different ETFs took second, seventh and 10th place as compared to five-year performance rankings. Market Vectors Biotech (BBH), an ETF that was incepted at the end of 2011 (and therefore lacks a five-year performance figure) ranked second-best on a three-year basis as of June 30, 2015. Seventh place would have gone to the only top ETF not tracking the health care sector, the Guggenheim Solar ETF (TAN). This ETF tracks the MAC Global Solar Energy Index and invests in U.S. stocks, foreign stocks, American depositary receipts (ADRs) and global depositary receipts (GDRs). Unlike the Market Vectors Biotech ETF, Guggenheim Solar ETF has been around since 2008. SPDR S&P Health Care Services (XHS) would have come in 10th place. The ETF was launched in September of 2011 and therefore lacks five years of return data.

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.

Table 1 shows the top ETFs by category. Five-year performance was calculated through June 30, 2015, to match the statistics displayed in “The Individual Investor’s Guide to Exchange-Traded Funds 2015,” which was published in the August 2015 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, 2015) 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 fund shares have traded at over the period.

The online version of this article, available on AAII.com, contains a list of the 50 top-performing funds, as opposed to the top 10 displayed in the print edition.

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. 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.

Related

Feature

The Individual Investor’s Guide to Exchange-Traded Funds 2015

Related

Exchange-Traded Funds

Using ETFs in a Tough, Sideways-to-Bear Market

Related

Mutual Funds

The EZ Approach to ETF Portfolio Building